Exchange rate is one of the key indicators affecting macroeconomic performance, and inflation is one of the most important indicators which represents the macroeconomic performance. The aim of this paper is to identify the relation between these two important economic variables. By using the model of structural time series and Kalman Filter algorithm the effect of exchange rate gap (the difference between official exchange rate and parallel market exchange rate) on inflation in Iran has been investigated during 1961- 2012. The results of this paper indicate that exchange rate gap has a significant positive impact on inflation in Iran, so that 1 percent increase in exchange rate gap lead to 3 percent increase in inflation in Iran. These results have approved the single currency policy to control inflation in the country.
