Application of Discrete Wavelet Transform in Investigating the Relationship between Inflation and Exchange Rate in the Iranian Economy

Abstract

The relationship between rate and inflation has a significant important for economies like Iran in two ways. On the one hand, policymakers by believing in a one-way relationship between the exchange rate and inflation try to control the general level of prices, which in practice has not been successful. On the other hand, activists of financial markets, considering the importance of exchange rate in other markets and also the lack of depth in financial markets, try to use the exchange rate as a shield against inflation and to maintain the value of their assets. In this regard, this study attempts to examine the causal relationship between inflation and exchange rate in the field of frequency and different time horizons using the discrete wavelet transform while eliminating the limitations of traditional econometric methods. For this purpose, the statistical population of Iranian economy and monthly data in the period 1991-2020 has been used. The results of the analysis show that in the long run, the causal relationship is from inflation to the exchange rate. This issue indicates that anchoring the exchange rate is not a proper policy to control inflation.