Political Economy of Financial Instability in Iran; Can the Government Secure Financial Stability?

This study examines the role of the government in financial stability in Iran. By analyzing data and deriving relevant indices, the paper shows that even without a zero lower bound— which in advanced economies marks the limits of monetary policy and justifies fiscal intervention— it remains essential to assess the government’s capacity in Iran. By using an NK-DSGE model, three scenarios of the government’s response to financial instability are examined: (i) non-intervention, (ii) transfer of funds to banks, (iii) stimulus fiscal policy. The analysis reveals a trade-off between financial stability, output stabilization, and inflation. when financial stability and output stabilization are policy priorities, fiscal policy proves more effective, although it is more inflationary. Both non-intervention and transfer of funds are inflationary, yet avoiding fiscal stimulus may lead to a stagflation. As far as financial stability is concerned, even non-intervention performs better than transferring funds. Moreover, the channels through which government expenditure is financed have distinct effects: government bank financing, when announced, increases inflation and weakens financial stability, whereas private bank financing results in lower inflation and greater financial stability. The situation is very different under fiscal shocks, financing through private banks weakens financial stability, while government ones enhance it. Finally, the average fiscal multiplier is 0.7691, indicating that the impact of fiscal stimulus is limited. All in all, these findings suggest that the government's influence on financial stability is constrained by its policy priority and financing mechanism of public expenditure.