Investigation of Inflation Response to Contractionary Monetary Policies in Islamic Banking System of Iran Based on Dynamic Stochastic General Equilibrium Modeling (DSGE)

Abstract

In Iran, the Monetary and Credit Council determines the rate of interest in terms of inflation rate and in a normative way. Critics of the country's banking system believe the issue is incompatible with the spirit of Islamic banking (i.e. sharing profits and losses). And Islamic banking is anti-business cycles, which is not possible in Iran's current banking system. This article examines the importance of the cost channel according to the new Keynesian model of the business cycle, considering the implementation of monetary policies based on Islamic banking system in Iran. And it tests the conditions under which the pattern can produce a positive response to inflation in a monetary contraction situation. The data used at constant prices in 2011 are annually for the period during 1966-2016 from the data of the Central Bank of the Islamic Republic of Iran. First, the model was linearized around the fixed point of the logarithm, and then its parameters were estimated using studies and facts revealed in the literature of Dynamic Stochastic General Equilibrium. Finally, using Blanchard and Kahn approach in Matlab software it was investigated by calculating and drawing graphs of instantaneous reaction functions. Inflation and capital rental rates move in the opposite direction after a contractionary monetary policy. Therefore, policymakers at the central bank should not worry about the short-term rise in inflation following a contractionary monetary policy.

Keywords

• price puzzle
• new keynesian model
• contractionary monetary policy
• islamic banking
• cost channel
• iran