Financial markets, inflation and growth: The impact of monetary policy under different political structures

Abstract

This study assesses the likely effects of different political structures on economic growth by the effects of interest rate on the linkage between financial markets. For this aim, we chose two developing economies with different governance structures, Iran and Argentina. There is a political structure in Iran influenced by religion, whereas Argentina’s political structure does not deal with religion. We first assess the causality amongst the financial markets of the stock market, bank deposits, and the foreign currency market (CM). Then, the effects of the markets and inflation on economic growth are assessed using Granger-causality tests and Markov-switching models. The results show that there are bidirectional causalities between the financial markets in Iran, and unidirectional causalities in Argentina. The markets affect economic growth in the both countries. For Iran, the monetary policy instrument of interest rate indicates no causalities to the markets, whereas there are strong causalities from interest rate to the markets in Argentina. As a result, Argentinian Central Bank can affect economic growth through the money flow between the markets by freely changing interest rate proportioned with the economic situation. Whereas there is no such a possibility for Iran’s Central Bank. In other words, an active Central bank against the inflation volatility in Argentina versus a passive Central Bank in Iran is one of the consequences of the interest rate repression in a political structure influenced by religion.