The Dynamics of Inflation and Exchange Rate Pass-Through in Iran: An Application of the Markov Regime-Switching Model

This study investigates the short- and long-term interactions between inflation and the real exchange rate in the Iranian economy over the period from February 2002 to September 2025. By employing a Markov Switching framework, the analysis captures the effects of structural changes and behavioral differences of variables under different economic conditions (boom and recession). The results indicate that during periods of economic expansion, exchange rate shocks gradually and partially affect price levels, reflecting price stickiness, delays in the pass-through of import costs, and managed inflation expectations of economic agents. In contrast, during recessions, the effect of the exchange rate on inflation is almost complete, and even minor exchange rate fluctuations can exert substantial inflationary pressures. Granger causality and variance decomposition analyses show that the exchange rate plays a leading role in determining inflation dynamics, while inflation has no significant effect on the exchange rate, consistent with Iran’s historical experience of exchange rate volatility and sanctions. The findings underscore the necessity of dynamic, long-term exchange rate management, indicating that monetary and fiscal policies alone are insufficient. Their combination with exchange rate policies and expectation management, particularly during recessions, is crucial to mitigate severe inflation volatility and maintain macroeconomic stability. This approach involves continuous monitoring of the exchange rate–inflation relationship, diversifying monetary policy tools through macroprudential policies alongside interest rate adjustments, paying special attention to recession periods when exchange rate effects on inflation are complete, and conducting complementary analyses by incorporating uncertainty indices, government fiscal policies, public debt, and external shocks. Long-term monitoring and policy adaptation to economic developments can help manage the complexities of the exchange rate–inflation relationship and strengthen Iran’s macroeconomic stability.