Exchange Rate and Money Supply Shocks, Fiscal Balance, and External Stability in Iraq: Evidence from an SVAR Model

Abstract

The study investigates the dynamic interdependence between Iraq’s exchange rate policy and money supply, with particular emphasis on how their interactions affect internal and external economic equilibrium. Internal balance is represented by the net general budget, whereas the balance of payments serves as the indicator of external balance. Using annual observations spanning 2004–2024, the analysis employs two three-variable structural vector autoregressive models, identified through short-run recursive restrictions grounded in monetary theory and the institutional characteristics of a rentier economy. Before model estimation, the time-series properties and underlying relationships are examined through unit root, cointegration, causality, optimal lag selection and residual diagnostic tests. The findings establish that all variables are integrated of order one and exhibit cointegration. Bidirectional causal relationships are identified between the general budget and both monetary variables, as well as between the money supply and exchange rate. Conversely, causality involving the balance of payments operates exclusively from the money supply and exchange rate towards the external balance indicator. Both estimated models fulfil the stability requirement, with maximum characteristic root moduli of .845 and .873. Forecast error variance decomposition further reveals an increasing contribution from exchange rate and monetary fluctuations, with their respective shares reaching 17.82% and 13.71% at the tenth forecast horizon. The exchange rate demonstrates a comparatively greater influence on both internal and external balances, suggesting that Iraq’s currency auction mechanism constitutes the principal adjustment channel, rather than monetary expansion operating independently.