This paper studies determinants of inflation in Iran. The buildup of international reserves has accelerated in response to the higher oil price. Further, the associated increase in government spending has limited contribution to capacity building and pronounced inflationary pressures, which appears to have been accelerated at the beginning of the Iran-Iraq war in 1980, and eased at the end of the war in 1988. Accommodating monetary stance has proven to be an important determinant of inflation, both in the long and short-run. In the long-run, depreciation of the rial increases the cost of intermediate goods, increasing inflationary pressures with limited significant effect on output supply in light of inelastic demand for imports. In contrast, depreciation could boost competitiveness of non-energy exports, in support of higher demand and output growth in the short-run. For policy implications, priorities should be in place to direct both public and private resources towards relaxing binding capacity constraints, capitalizing on the added windfall of abundant oil resources in Iran. Aligning the effective exchange rate with underlying fundamentals will help boost competitiveness and stem inflationary pressures that could prove detrimental to non-energy export competitiveness, hampering efforts to diversify resources and expand capacity to sustain output growth over time.
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