Inflation reacts to monetary policy tightening using the DSGE model

Abstract

The cost channel is studied in monetary policies using the new Keynesian model of business cycle. In this article, we explore when the model can produce a favorable inflation response during a situation of monetary tightening. This article utilizes stable price data sourced from the Central Bank of the Islamic Republic of Iran spanning from 1982 to 2022. Initially, the model was linearized based on the stable growth trajectory, and its parameters were calculated using information and findings from DSGE literature. Next, they were evaluated using the Blanchard and Kun method in Matlab software by creating impulse response functions. The findings indicate that how inflation reacts to monetary policy tightening depends on the cost channel parameter's value. Following the implementation of monetary policy, inflation rates and capital rent rates demonstrate opposite movements. Therefore, policymakers should not panic over the temporary increase in inflation after implementing stricter regulations