State-Space Analysis of Financial Market Convergence and Economic Development in Iran: A Kalman Filter Approach

Abstract

The present study employs a parameter estimation method with time-varying coefficients and the Kalman Filter approach to conduct a state-space analysis of the convergence between the financial market and economic development in Iran from 1996 to 2023. The results obtained from the estimation of the state-space model (Kalman Filter) indicate that financial development, governance quality, rentier income, trade volume, and employment contribute to economic development by 6%, 0.2%, 7%, 10%, and 3%, respectively. Additionally, for every one percent increase in inflation rate and exchange rate, economic development declines by 2% and 7%, respectively. Moreover, the estimated parameters of the state-space model using the Kalman Filter reveal that the elasticity of economic development relative to financial development over the period under study is less than one. Specifically, between 1996 and 2005, the relevant sensitivity coefficient was 0.16. From 2010 to 2023, the elasticity of economic development with respect to financial development follows a declining trend. It is important to note that the implementation of financial market development processes does not necessarily result in growth or positive effects and requires structural alignment of the domestic economy, economic regulation, coordinated policies, and macroeconomic stability. Furthermore, an examination of the sensitivity of economic development to rentier income shows that the average sensitivity throughout the study period is less than one, approximately around 3%. In other words, with an increase in oil prices in the Iranian economy, capital is directed not into the productive and value-added sectors, but rather into imports. This diversion is a response to the country's stagflation conditions, intended to counter inflation. As a result, the productive sector faces serious harm, with many production units exiting the economic cycle. Capital that would otherwise be utilized in the productive economy remains stagnant and is inevitably redirected toward the black market and speculative activities.