Simulating the effect of inflation targeting on money supply and inflation in Iraq

Abstract

Inflation targeting, as one of the most important monetary policy frameworks, has been Inflation targeting has been widely adopted by many countries in recent decades with the aims of stabilizing the general price level, controlling liquidity growth, and enhancing the credibility of monetary policy. However, the effectiveness of this framework in oil-dependent economies with institutional constraints, such as Iraq, remains a subject of debate. The main objective of this study is therefore to simulate and examine the impact of inflation targeting on money supply and the inflation rate in the Iraqi economy. To achieve this goal, annual time-series data for the Iraqi economy covering the period 1975–2024 were employed. The dynamic relationships among inflation targeting, money supply, and the inflation rate were analyzed using a vector autoregression (VAR) model. Prior to estimation, the stationarity of the variables was assessed using the Augmented Dickey–Fuller test. The optimal lag length was selected on the basis of information criteria. Impulse response functions and forecast error variance decomposition were then applied to evaluate the dynamic effects of inflation-targeting shocks. The results of the impulse response functions indicate that shocks arising from inflation targeting do not exert a significant or stable effect on money supply; the response of this variable remains limited, short-lived, and unstable. In contrast, the impact of inflation targeting on the inflation rate emerges with a time lag and contributes to a gradual reduction in inflationary fluctuations over longer horizons, although the magnitude of this effect is relatively modest. Variance decomposition analysis corroborates these findings: the contribution of inflation targeting to explaining fluctuations in money supply remains negligible across all time horizons, while its contribution to explaining changes in the inflation rate increases gradually. Nevertheless, the bulk of inflation fluctuations continues to be driven by endogenous inflation shocks and other structural factors specific to the Iraqi economy. Overall, the results suggest that, under Iraq’s current institutional and structural conditions, inflation targeting has not yet functioned as an effective nominal anchor for liquidity control, although it may contribute modestly to dampening inflationary fluctuations in the long run. These findings underscore the need to strengthen central bank independence, reduce fiscal dominance, develop monetary policy instruments, improve monetary transmission channels, and enhance coordination between monetary and fiscal policies in order to increase the effectiveness of inflation targeting in Iraq.