Optimal Monetary Policy in a Dual Exchange Rate Regime

In this study, we design a structural macro model for Iran’s economy in which there is a dual exchange rate regime, namely, official (fixed) and unofficial (floated) rates. The central bank determines the official rate, whereas the unofficial rate is set in the free market. The structural parameters of the designed model are estimated using quarterly data in the 1991-2019 period and the Bayesian method. The main finding of this paper is that establishing a dual exchange rate regime cannot prevent the harmful effects of exchange rate dynamics on macro variables. Therefore, it is better to abandon this strategy, and instead, the central bank put forward the optimal response to exchange rate dynamics. To do this, we derive an optimal policy rule for the central bank and show that the best policy is assigning equal weights to the inflation rate and output gap in loss function and active response to both inflation rate and exchange rate in the policy rule.