The Effect of Monetary Policy Credibility on Inflation in Iraq: Application of the Bayesian VAR Method

Riyadh Mohammed Hassoon; Habib Aghajani; Sakineh Sojoudi; Jafar Haghighat

Authors

Riyadh Mohammed Hassoon Ph.D. of Science in Economics, Monetary Economics, Faculty of Economics and Management, University of Tabriz, Tabriz, Iran https://orcid.org/0009-0001-1271-601X
Habib Aghajani Associate Professor, Department of Economics, Faculty of Management and Accounting, University of Tabriz, Tabriz, Iran Author https://orcid.org/0000-0002-0837-1012
Sakineh Sojoudi Associate Professor, Department of Economics, Faculty of Management and Accounting, University of Tabriz, Tabriz, Iran Author https://orcid.org/0000-0002-2109-3555
Jafar Haghighat Professor, Department of Economics, Faculty of Management and Accounting, University of Tabriz, Tabriz, Iran Author https://orcid.org/0000-0002-5470-5220

Keywords:

monetary policy credibility, inflation, expected inflation, state, space model, Kalman filter, BVAR model, Iraq

Abstract

This study aimed to examine the effect of monetary policy credibility on inflation dynamics and inflation expectations in Iraq over the period 2004–2023. The primary focus of the study was to determine whether greater central bank credibility can anchor inflation expectations and reduce the magnitude and persistence of inflation. First, expected inflation was extracted as a latent variable using a state-space model and the Kalman filter. The monetary policy credibility index, denoted by CRED, was then calculated based on the deviations among actual inflation, expected inflation, and the long-run trend of inflation. Subsequently, the dynamic relationships among inflation, the policy interest rate, expected inflation, gross domestic product, and monetary policy credibility were examined using a Bayesian Vector Autoregressive (BVAR) model with a Minnesota prior and two lags. The Augmented Dickey–Fuller stationarity test, Johansen cointegration test, impulse response functions, and forecast error variance decomposition were also employed to analyze the results. The state-space model results indicated that expected inflation exhibited temporal persistence, with a persistence coefficient of 0.48. In addition, the positive effect of lagged actual inflation on expected inflation, with a coefficient of 0.12, confirmed the role of adaptive expectations in the Iraqi economy. In the BVAR model, the coefficient of the first lag of inflation in the inflation equation was 0.2137, indicating inflation persistence. The coefficient of the first lag of the monetary policy credibility index in the inflation equation was estimated at −0.0919; therefore, greater monetary policy credibility was associated with lower inflation. The variance decomposition results showed that at the 10-period horizon, 99.5881% of inflation fluctuations were explained by inflation’s own shock, whereas 0.1187% were explained by shocks to monetary policy credibility. This finding suggests that the effect of monetary policy credibility is neither direct nor immediate but is transmitted primarily through inflation expectations and develops gradually over time. The findings indicate that, despite its limited direct contribution to explaining inflation fluctuations, monetary policy credibility plays an important role in anchoring expectations and reducing inflation persistence in Iraq. Accordingly, increasing the transparency and predictability of central bank decisions, strengthening monetary–fiscal policy coordination, developing financial markets, and reducing dependence on oil revenues can enhance monetary policy credibility and contribute to sustainable price stability in Iraq.

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