Islamic Republic of Iran : Managing the Transition to a Market Economy

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• eBook ISBN:
  9781589064416
• Year: 2007

NONE

Chapter 1: Economic Growth

Iran faces the challenge of increasing its growth rate to reduce unemployment and improve the living standards of its population over the medium term. Growth performance in recent years (6 percent during 2000–03) has been satisfactory and has been driven by major economic reforms as well as transitory factors such as high oil prices and expansionary fiscal and monetary policies. However, questions arise about the determinants of growth in Iran and the long-term sustainability of relatively high growth rates. Because past experience shows that the Iranian economy can grow at relatively high rates over an extended period, the first step is to examine the historical sources of growth and discuss the relevance of various contributing factors for the medium term. The second step is to provide an analytical framework for the formulation of growth-enhancing policies.

This chapter uses a growth accounting exercise to quantify the historical sources of growth during the period 1960–2002, including human capital accumulation and the contribution of TFP to growth. The chapter also presents an empirical study to quantify the role of several other contributing factors commonly discussed in the cross-country growth literature, including macroeconomic stability, financial development, trade openness, and changes in the terms of trade.¹

Historical View of Growth Performance

During 1960–2002, real GDP growth in Iran averaged 4.6 percent per year (2 percent in per capita terms). Non-oil GDP grew at a faster pace of 5.5 percent during this period.² There are three distinct subperiods (Figure 1):

• During 1960–76, Iran enjoyed one of the fastest growth rates in the world: the economy grew at an average rate of 9.8 percent in real terms, and real per capita income grew by 7 percent on average. As a result, GDP at constant prices was almost five times higher in 1976 than in 1960. This stellar performance took place in an environment of relative political stability, low inflation (Figure 2), and improved terms of trade, as evidenced by the rising oil price relative to import prices (Figure 3). Both oil output and oil prices increased significantly during the period: oil production grew at an annual average rate of 10 percent, while oil prices relative to import prices increased by 214 percent during this subperiod.
• The growth trend was reversed during 1977–88, reflecting the turmoil in the aftermath of the 1979 revolution, the eight-year war with Iraq, the international isolation of Iran, the increased state dominance of the economy, and the plummeting of oil output and revenue. In 1988, oil production was only 36 percent of its 1976 level, and oil prices were 40 percent lower in real terms. This resulted in real GDP growth of Ó2.4 per year on average. Excluding oil output, non-oil GDP also declined, albeit at a more moderate pace (0.5 percent per year).
• With the reconstruction effort and a partial recovery in oil output, real economic growth recovered during 1989–2002 to an average of 4.7 percent per year. This period, however, was marked by sharp fluctuations in the growth pattern, as the postwar economic boom (1989–93) was followed by the stagnation of 1993–94, when the economy was hit by lower oil prices, lack of external financing, and economic sanctions. The ensuing severe debt crisis, together with inappropriate macroeconomic policies, had an adverse effect on growth, which hovered around 3.6 percent from 1995 to 2000. During 2000–03, real GDP growth picked up to 6 percent as a result of significant progress in economic reforms—such as trade liberalization, exchange rate unification, an opening up to FDI, and financial sector liberalization—but also because of high oil prices and expansionary fiscal and monetary policies.

Figure 1. GDP Growth Rates, 1960–2002

(Annual percentage change)

Sources: Iranian authorities; IMF staff estimates.

Figure 2. Inflation, 1960–2002

(Annual percentage change; end-period)

Sources: Iranian authorities; IMF staff estimates.

Figure 3. Oil GDP and Oil and Import Prices Ratio, 1960–2002

Sources: Iranian authorities; IMF staff estimates.

The growth performance of Iran compares favorably with that of the rest of the countries in the Middle East and North Africa (MENA) region, which averaged 4.2 percent per year during 1960–2002 (Table 1). Among the 17 countries in the region, only four—Oman, the Syrian Arab Republic, the United Arab Emirates, and the Republic of Yemen—grew faster than Iran. However, historical growth in Iran also exhibits higher variability than in the rest of the region.

Table 1. MENA Region: Economic Growth, 1960–2002

(In percent, average for the period)

Source: IMF, International Financial Statistics (IFS).

¹ Excluding Iran.

Determinants of Economic Growth

The empirical studies on the determinants of growth can be broadly divided into two main categories. The first includes growth accounting exercises, which consist of estimating the contributions to growth of basic factor inputs—labor, physical capital, and human capital—and a residual that captures the efficiency at which physical and human capital resources are used, or TFP. The second comprises several empirical studies analyzing cross-country growth regressions to find the relationship between different explanatory variables and growth.

Growth Accounting

A standard growth accounting framework is used to discuss the historical sources of growth in Iran. We use the following Cobb-Douglas production function:

where Y, K, and H represent output, physical capital, and human capital, respectively; α represents the contribution of physical capital to output; and t is an index for time. The term A represents TFP, or the efficiency at which the economy operates, which depends on factors such as the domestic political and international environment, the legal and regulatory framework, the creation and diffusion of more efficient technologies through international trade or FDI, and the effect of structural reforms, such as financial sector or labor market liberalization. Physical capital is considered as a homogeneous capital good, with no distinction made between equipment and nonequipment capital goods or between private and public capital goods (implicitly assuming that the productivity of the two types of capital is the same).³

To account for the effect of education on economic growth, a human capital index is constructed as a function of both the labor force and average years of schooling. However, in Iran it is difficult to measure the contribution of schooling to human capital because of the lack of an education quality index that would account for the changes in the productivity of education during 1960–2002..⁴ Therefore, the paper considers two different specifications of human capital, which result in two different growth accounting exercises.

A basic specification is to make human capital equal to raw labor, that is, H_t = L_t. Under this specification, an increase in the average years of schooling of the labor force does not increase the productivity of labor. Given that the crosscountry empirical evidence points to a positive effect of education on the productivity of labor, under this simple specification, the contribution of TFP to growth is overstated because it implicitly takes into account the effect of the quality of the labor input on output and growth.

A different assumption is to consider that schooling increases the productivity of the labor force along the following specification of human capital (Lucas, 1988):

where L represents the labor force and e is the average years of schooling of the labor force.

The above-specified production function implies that human capital accumulation exhibits increasing returns to scale. This means that if we double both the number of workers and the average years of education for the labor force, human capital increases fourfold. Because anecdotal evidence—such as the increased proportion of college graduates with nonmarketable skills—points to a reduction in the quality of education in Iran over the period under study, the growth accounting exercise using this technology specification may result in an overstatement of the contribution to growth of human capital and an understatement of the contribution of TFP.

Taking natural logarithms and differentiating with respect to time, the following decomposition of growth is obtained:

where g denotes the growth rate of the variable in the subscript. If factor markets are competitive, the first-order profit-maximizing conditions for the firm imply that α corresponds t...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Acknowledgments
• Abbreviations
• Preface
• Introduction
• 1. Economic Growth
• 2. The Financial Sector: Issues and Reforms
• 3. Moving toward a Market-Based Monetary Policy
• 4. Approaches to Assessing the Exchange Rate Level
• 5. Issues in Medium-Term Management of Oil Resources
• Appendixes
• Bibliography
• Boxes
• Footnotes