External Debt and Exchange Rate Fluctuations in Iran: Markov Switching Approach

Abstract

When net External assets change, the money supply of a country and also the central bank’s debt will change. Exchange rate is much more important in countries like Iran, because a great portion of government’s revenue comes from the External exchange of natural resources. So, exchange rate directly influences the government’s financial situation, revenues, and costs. As External debt is one of the main financing resources of budget deficit, thus how it will be spent can positively or negatively affect the exchange rate fluctuations. This research tried to study the effect of External debt on exchange rate by using monetary approach to exchange rate, and to that end used time series data for 1981–2017 period. In addition, due to the nonlinear relationship between the variables based on the LR and BDS test, nonlinear models were used to estimate. The results show that External debt and money supply have positive and significant effect on exchange rate. So, monetary policy can derivate the exchange rate from its long-run trend. In contrast, the difference between domestic and external production has a negative and significant effect on the exchange rate.