This article is about the social turmoil in Iran as a result of inflation, a persistent increase in the average price level, which is pulling up the prices of necessities, in particular food. The current inflation in Iran is due to higher costs of imported feed, a supply shock which is driving up the cost of producing food. Therefore, it is an example of cost-push inflation triggered by import pressures (Diagram 1).
Initially, the equilibrium in the Iranian economy settles at point A. A rise in the price of feed will increase the production costs of firms, and this makes it less profitable for businesses to sell, so the amount of goods and services supplied by firms at any given price level in the short run, known as short-run aggregate supply (SRAS), will decrease. Thus, the SRAS curve shifts to the left from SRAS1 to SRAS2. The equilibrium will move to point B with a higher price level P2 and a lower level of output Y1.
As the inflation rate in Iran rises to 10% due to an increase in the average price level from P1 to P2, economic growth shrinks due to a fall in the level of output from Yf to Y1. Because Iran is experiencing inflation together with stagnation (falling output), this event is called stagflation. Unemployment in Iran also remains high. Stagflation results in firms producing a lower level of output, hence a smaller workforce will be required, and unemployment rises. Therefore, a leftward shift in aggregate supply leads to higher inflation, lower economic growth, and higher unemployment, worsening the trade-off between the macroeconomic objectives.
Firms may respond to inflation by raising nominal wages to avoid discontent among workers, increasing further firm’s costs and aggravating inflationary pressure. However, the purchasing power of Iranians will drop with inflation due to higher unemployment, and investment will be discouraged due to economic stagnation, so the low level of employment and output will put downward pressure on wages. As a result of falling wages, SRAS will shift back to its original position at SRAS1, and the economy might return to point A in the long run.
The Iranian government, however, may not let the market operate freely and could attempt to combat cost-push inflation by influencing aggregate demand (AD), the total spending on goods and services in an economy, through fiscal or monetary policies (Diagram 2). A shift of the AD curve to the right from AD1 to AD2 would return output to full employment level Yf. Therefore, demand-management policies aimed to accommodate the increase in feed prices would prevent a reduction of output in the short run, but inflation would worsen as the price level would rise from P1 to P3, resulting in a permanently higher price level P3.
An alternative solution would involve the implementation of supply-side policies. These are a set of measures designed to increase long-run aggregate supply (LRAS), the output when all available resources are being used efficiently, leading to economic growth. An outward shift of the LRAS curve from LRAS1 to LRAS2 results in a fall in the average price level from P2 to P1 and an increase in potential output from Yf1 Yf2, counterbalancing cost-push inflation (Diagram 3). This can be achieved by improvements in the quality of factors of production or an increase in their quantity.
The government could opt for market-based supply-side policies, aiming to increase incentives and productivity, or interventionist supply-side policies, actively encouraging economic growth. In the first case, liberalizing trade through a reduction in import tariffs would decrease the price of feed imports and so import-push inflation. Cutting down tariffs might improve the efficiency of domestic producers, but it would result in a lower revenue gain for the government. Secondly, state investment in education and training would be successful in targeting structural unemployment arising from occupational immobility as the quality of labour would improve. However, the funding of these projects represents substantial public spending which may worsen the national budget. The disadvantage of supply-side policies is the lengthy time-lag between their implementation and the effect on real output; they may not be effective in targeting the short-run effects of cost-push inflation.
In conclusion, inflation in Iran is having major drawbacks on economic growth and unemployment. Although demand-management policies may successfully mitigate the adverse impact on output and employment in the short run, this is done at the cost of inflation, so supply-side policies may be more efficient in bringing back economic stability to Iran in the long run.
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