Modeling Inflation Dynamics of the Iran’s Economy; P-Star Approach (Using ARDL and State-Space Models)

Abstract

The association between money and prices has long been debated in various economic schools. Although there are different views, most economists agree that in the long run, inflation is a monetary phenomenon and its main cause is liquidity growth. Several models have been designed in order to clarify the monetary aspect of inflation, how to forecast it and the awareness of how it moves in the economy. One of the models that have been considered recently is the P-Star model which draws on the quantity theory of money. The framework of P-Star model is based on the fact that inflation in long run is a monetary phenomenon and the price level moves proportional to the money supply in the economy. In this research by using seasonal data of Iran, two different alternatives of P-Star model have been tested by considering liquidity gap, velocity gap and output gap. In order to estimate the liquidity gap, ARDL Approach has been used to estimate the demand for liquidity. For velocity of money gap, Hodrick-Prescott filter was Applied and by using state-space models and the Kalman filter, output gap was estimated. The results indicate that the P-Star model with liquidity gap and velocity and output gap have satisfactory explanatory power of inflation. According to the outcomes of static and dynamic forecasts, the P-Star model with liquidity gap has higher predictive power of inflation.