Concerns Over War-Driven Inflation

In the first part of this article, the authors review the impact of war on the economies of Iran and the Persian Gulf region, examining how recent conflict has affected inflation and exchange rates and assessing its effects on different social groups.

In the first part of this article, the authors reviewed the effect of the war on the economy of Iran and the Persian Gulf region, analyzed the effectiveness of inflation and the exchange rate of the recent war and measured its effect on different strata.

According to Ambassador Arjan, quoting information, the article you are reading has tried to examine the situation that the recent US military aggression has created for Iran's economy and mix this situation with the fundamental issues of the country's economy.

In this article, we examine the prospects of Iran's economy, and our main focus is on the current and likely future trends in production, inflation, and exchange rates. Our analysis is based on several different scenarios. Our central scenario is relatively positive: a state of non-aggression, i.e. a hostile but stable ceasefire. Of course, there is also a negative scenario in which conflicts continue, oil exports are limited, exchange rates increase, inflation accelerates, and the economy moves towards a state of siege.

Iran's military actions so far have mainly relied on the stockpile of weapons accumulated before the wars. If the conflicts continue, increased production - both for new ammunition and for reconstruction - will be necessary. From a monetary perspective, the government budget constraint requires that increases in military spending be financed through increases in government debt or reductions in public spending, subsidies, or transfer payments. Additionally, there are real (not just monetary) resource constraints, especially in the case of strategic materials. Due to increased demand, monetary financing and certain shortages, there is a risk that inflation will turn towards hyperinflation. However, any discussion of the scenario of the continuation of the conflict is speculative in nature and depends on the form that the conflict takes. So far, this conflict has been like a "game of chicken" in many ways, that is, which side will be the first to fail. Although there is a risk that none of the parties will fail and the conflict will escalate.

In our previous working paper (Pesran and Smith, 2026), we proposed a transition to a regional security-based, cooperation-based military that would be financed through service tolls for crossing the Strait of Hormuz, similar to the tolls that Turkey charges for crossing the Bosphorus and Dardanelles. This plan is a promising option because it aligns with the incentives of all parties and benefits both oil exporters and our shippers and consumers.

We argued that such a system would align costs with benefits, reduce dependence on externalities, and promote long-term stability, ultimately leading to more stable and lower oil prices in the long run. The plan would also be a huge benefit to American taxpayers.

From an external point of view, Iran's economic prospects depend on the security and economic arrangements reached between Iran and its neighbors in the Persian Gulf and beyond. Other Persian Gulf countries are facing severe consequences from the closure of the Strait of Hormuz. Bahrain, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates depend on safe hydrocarbon exports, food and intermediate goods imports, and trust in regional transportation and financial hubs.

In addition, the ports, refineries, pipelines, desalination facilities and air corridors of these countries are exposed to a war that they did not initiate and cannot end. The increase in transportation and insurance costs will also weaken investment and economic diversification. These damages extend beyond the region through increased energy, transportation and insurance costs, inflation and slowing growth; The heaviest burden of these damages falls on the shoulders of developing countries that import energy, indebted governments and households, whose major expenses are spent on food, fuel and transportation.

From an internal point of view, the progress depends on Iran's economic policy and whether it can reform the socio-economic system in a way that would make it possible to take advantage of any cessation of conflicts.

In the past, Iran has suffered not only from sanctions and wars, but also from economic mismanagement and corruption, which was often aggravated by the tactics of evading sanctions.

In addition, there should be an overview of the evolution of Iran's economy, focusing on production, inflation and exchange rate, and the role of previous and current policies in the current situation should be evaluated. This review begins by examining the performance of exchange rates (the free market rate and the official rate of the US dollar against the Rial), which have been volatile and sensitive to geopolitical influences, especially expectations about the scope and severity of sanctions and the possibility of military conflicts. The exchange rate is the main driver of inflation, and controlling inflation is one of the central policy issues, because inflation in Iran has a chronic nature and its upward trend has continued over time, considering that Iran's recent inflation has been at its highest level since World War II.

It is clear that geopolitical events direct the exchange rate and the exchange rate also directs inflation. As statistical data shows, inflation appears as wave jumps and each peak is usually higher than the previous peak. Although these figures are high, they are not close to the monthly hyperinflation threshold, but there is high volatility in monthly inflation rates and will undoubtedly return to higher levels as long as the sanctions and wars against Iran continue.

In addition, it should be stated that although inflation has not yet accelerated to levels that can be considered hyperinflation, there is a risk that it will become so if the war with America continues during the next year or close to it. According to the conventional narrative, high inflation turns into hyperinflation when people completely lose confidence in the national currency and try to spend it as quickly as possible. This collapse of confidence may occur as a result of a rush to the national currency or an over-expansion of the money supply to finance the government's budget deficit.

As mentioned earlier, inflation changes in Iran are mainly related to external geopolitical shocks on the exchange rate, which are accepted and accompanied by the monetary authorities. In the long term, the consumer price index has moved in the same direction as the exchange rate, although in the short term, the exchange rate has been very unstable and has exceeded the long-term relationship of purchasing power parity and has become overexcited.

Although high inflation is destructive in many ways, especially in the distribution of income and wealth and in relative prices, it can also have negative effects on productivity and growth. The negative effects of high and growing inflation on production growth are not necessarily so great; Domestic producers, farmers, artisans as well as shopkeepers suffer from the instability of the exchange rate and high and growing inflation, but they have the advantage of being able to pass on higher prices to consumers with high frequency. But this is not possible for wage earners and pensioners, because they have to increase their income through protests, pressure groups, associations and trade unions.

In addition, it should be said that high inflation can be maintained for a long time without transitioning to hyperinflation. This transition can be triggered by various factors, from excessive monetary financing of the budget deficit to currency crisis. The structure of labor market institutions is important in determining the nature of the inflationary process. If wages are controlled and unable to respond to prices due to the nature of the wage-setting process, the accelerating wage-price spiral at the heart of hyperinflation cannot occur.

Meanwhile, the central issue is the power of the nominal anchor of inflation. This factor determines how much people trust the national currency and how credible the government is to maintain stable and non-accelerating inflation that returns to a balanced average after shocks caused by supply shortages or conflicting demands on limited resources.

Independent central banks certainly help fight inflation, but they are not a panacea. If the government runs a large budget deficit, the central bank cannot do much to control the growth of money or pseudo-money in the economy. The government's inability to finance its obligations can be caused by high costs arising from wars, subsidies necessary to maintain the political base, or accrued interest on the debt. Political pressures can also limit the government's ability to increase revenue; At the root of this situation is a conflict over the demand for resources between the government and the people. In addition, inflation expectations can turn into exchange rate expectations, which can be affected by geopolitical shocks; Therefore, inflationary expectations become political expectations.

Of course, the harmful effects of sanctions on production and inflation are only part of the story. In their working paper version, Laudati and Sons (2021) examine the wider socio-economic effects of sanctions. They show that the costs of sanctions have not been fairly distributed among different sectors of the economy, and that people in low-wage jobs, retirees, and women have been disproportionately affected. It has also been found that sanctions have had negative effects on employment, labor force participation, and secondary and high school education, and these effects have intensified for women. Compared to other countries in the Middle East and North Africa, Iran's employment rate has systematically decreased after the imposition of sanctions, and it seems that women have paid a heavier price for this. continues

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