Regime‐dependent effects of uncertainty on inflation and output growth: evidence from the United Kingdom and the United States

Employing a bivariate regime switching model, this paper attempts to examine the regime‐dependent effects of inflation uncertainty and output growth uncertainty on inflation and output growth. Using monthly data of the United Kingdom and the United States, we provide evidence that both nominal and real uncertainty exert regime‐dependent impacts on inflation. Furthermore, in case of both the countries, inflation uncertainty has adverse impact on output growth mainly during the period of economic contraction. Also, for these two countries, it can be argued that higher real uncertainty significantly reduces output growth only in their respective low output growth regimes.     

Macroeconomic Uncertainty and Performance in Asian Countries*

We use a very general bivariate GARCH‐M model and quarterly data for five Asian countries to test for the impact of real and nominal macroeconomic uncertainty on inflation and output growth. We conclude the following. First, in the majority of countries uncertainty regarding the output growth rate is related negatively to the average growth rate. Secondly, contrary to expectations, inflation uncertainty in most cases does not harm the output growth performance of an economy. Thirdly, inflation and output uncertainty have a mixed effect on inflation. Consistent results are found using the VAR‐GARCH‐M approach to investigate the dynamic relationship between inflation and output growth using impulse response functions. This evidence implies that macroeconomic uncertainty may even improve macroeconomic performance, i.e. raise output growth and reduce inflation. Our empirical results highlight important differences with those for industrialized countries.     

On the real effects of inflation and inflation uncertainty in Mexico

We estimate an augmented multivariate GARCH-M model of inflation and output growth for Mexico at business cycle frequencies. The main findings are: (1) inflation uncertainty has a negative and significant effect on growth; (2) once the effect of inflation uncertainty is accounted for, lagged inflation does not have a direct negative effect on output growth; (3) However as predicted by Friedman and Ball, higher average inflation raises inflation uncertainty, and the overall net effect of average inflation on output growth in Mexico is negative. That is, average inflation is harmful to Mexican growth due to its impact on inflation uncertainty. (4) The Mexican Presidential election cycle significantly raises inflation uncertainty both during the year of the election and the year following the election which has correspondingly negative effects on output growth.     

Modelling the Link Between US Inflation and Output: The Importance of the Uncertainty Channel

This article employs an augmented version of the UECCC GARCH specification proposed in Conrad and Karanasos (2010) which allows for lagged in‐mean effects, level effects as well as asymmetries in the conditional variances. In this unified framework, we examine the twelve potential intertemporal relationships among inflation, growth and their respective uncertainties using US data. We find that high inflation is detrimental to output growth both directly and indirectly via the nominal uncertainty. Output growth boosts inflation but mainly indirectly through a reduction in real uncertainty. Our findings highlight how macroeconomic performance affects nominal and real uncertainty in many ways and that the bidirectional relation between inflation and growth works to a large extent indirectly via the uncertainty channel.     

THE PARTISAN MODEL OF MACROECONOMIC CYCLES: MORE THEORY AND EVIDENCE FOR THE UNITED STATES*

The “Partisan Theory” of macroeconomic policy is based on the idea that political parties typically weight nominal and real economic performance differently, with left-party governments being more inclined than right-party ones to pursue expansive policies designed to yield lower unemployment and higher growth, but running the risk of extra inflation. Given suitable assumptions about the structure of the macroeconomy, partisan models imply a political signal in demand management, output and inflation movements originating with shifts in party control of the government. In this paper I develop and test with postwar US data a revised Partisan model that allows for (i) uncertainty among policy authorities about the sustainable output growth rate and therefore about how aggregate demand expansions will be partitioned between extra output and extra inflation, and (ii) ex-post and projective learning and preference adjustment under such uncertainty. Dynamic numerical analysis of a small, stylized political-economic model based on these extensions of Partisan Theory generates within-sample forecasts that correspond remarkably well to the observed pattern of price, output and nominal spending fluctuations under the parties.     

Regime Dependent Effects of Inflation Uncertainty on Real Growth: A Markov Switching Approach

We empirically investigate the effects of inflation uncertainty on output growth for the United States between 1960 and 2012. Modeling output dynamics within a Markov regime switching framework, we provide evidence that inflation uncertainty exerts a negative and regime‐dependent impact on output growth. A battery of sensitivity checks confirm our findings.     

Modifying Taylor reaction functions in the presence of the zero‐lower‐bound — Evidence for the ECB and the Fed

We propose an alternative way of estimating Taylor reaction functions if the zero‐lower bound on nominal interest rates is binding. This approach relies on tackling the real rather than the nominal interest rate. So if the nominal rate is (close to) zero central banks can influence the inflation expectations via quantitative easing. The unobservable inflation expectations are estimated with a state‐space model that additionally generates a time varying series for the equilibrium real interest rate and the potential output — both needed for estimations of Taylor reaction functions. We test our approach for the ECB and the Fed within the recent crisis. We add other explanatory variables to this modified Taylor reaction function and show that there are substantial differences between the estimated reaction coefficients in the pre‐ and crisis era for both central banks. While the central banks on both sides of the Atlantic act less inertially, put a smaller weight on the inflation gap, money growth and the risk spread, the response to asset price inflation becomes more pronounced during the crisis. However, the central banks diverge in their response to the output gap and credit growth.     

Nominal Wage Flexibility and Economic Performance: Evidence and Implications Across Industrial Countries

By considering the theoretical connection between labour and product markets, the paper evaluates the economic relationship of these markets within the contractual wage rigidity New Keynesian explanation of business cycles. The empirical analysis focuses on the short‐run cyclical behaviour of real output, prices and wages for 19 industrial countries. Time‐series and cross‐sectional regressions are estimated. Cross‐sectional cyclical correlations in the labour and goods markets are also evaluated across countries. Consistent with the theoretical predictions, aggregate uncertainty is an important factor in increasing the flexibility of the nominal wage in response to aggregate demand shocks. Wage flexibility accelerates price inflation and moderates the response of real output growth to aggregate demand shocks. Wage flexibility does not appear to be an important factor in differentiating the real and inflationary effects of energy price shocks across countries. Finally, aggregate uncertainty increases the responsiveness of output and price to productivity shocks.     

Foreign output shock in small open economies: A welfare evaluation of monetary policy regimes

We examine the impact of negative foreign output shocks, which entail negative demand side effects by lowering exports and positive supply side effects by lowering oil prices, on the welfare of non-oil producing, small open economies under five exchange rate and monetary policy regimes. We use a dynamic stochastic general equilibrium model with parameter values calibrated for Hong Kong, Israel, Singapore, South Korea and Taiwan. We find that welfare levels among the five policy regimes depend on the economy's share of oil imports in world oil consumption. Hong Kong, Singapore and Israel, which have smaller shares, maximize welfare under the Taylor rule, which targets both CPI inflation and real output. South Korea, with higher shares, and Taiwan, with more rigid prices, maximize welfare under real output targeting. CPI inflation targeting, nominal output growth targeting and fixed exchange rate regimes generate lower welfare. However, optimal monetary policy, which generates the highest welfare, gives greater weight on real output than CPI inflation.     

Exchange Rate Passthrough Effects and Inflation Targeting in Emerging Economies: What is the Relationship?

Several studies have shown that over the past 10 years the passthrough effect from currency depreciation into domestic inflation has been decreasing in emerging economies that adopted inflation targeting (IT) during the mid and late 1990s. Therefore the nominal exchange rate effect on domestic inflation is becoming less of an issue for these countries. The literature has offered different explanations for these declines but so far they have not been directly related to the adoption of IT. This paper shows that lower passthrough effects can also be the result of the implementation of an IT regime and argues, contrary to previous studies, that the effects of the nominal exchange rate on inflation are still a relevant issue for emerging IT countries. The reason for this is that the empirical evidence offered for the lower passthrough misses the nature of the relationship between inflation and the nominal exchange rate under IT.     

The inflationary bias of real uncertainty and the harmonic Fisher equation

Summary. We argue that real uncertainty itself causes long-run nominal inflation. Consider an infinite horizon cash-in-advance economy with a representative agent and real uncertainty, modeled by independent, identically distributed endowments. Suppose the central bank fixes the nominal rate of interest. We show that the equilibrium long-run rate of inflation is strictly higher, on almost every path of endowment realizations, than it would be if the endowments were constant.Indeed, we present an explicit formula for the long-run rate of inflation, based on the famous Fisher equation. The Fisher equation says the short-run rate of inflation should equal the nominal rate of interest less the real rate of interest. The long-run Fisher equation for our stochastic economy is similar, but with the rate of inflation replaced by the harmonic mean of the growth rate of money.Received: 25 February 2005, Revised: 26 May 2005, JEL Classification Numbers: C7, C73, D81, E41, E58.An earlier version of this paper “Inflationary Bias in a Simple Stochastic Economy,” as a 2001 Cowles Foundation Discussion Paper No. 1333.     

Asymmetric monetary policy and the effective lower bound

We use the canonical New Keynesian model to study optimal discretionary policy when the nominal interest rate is constrained by the effective lower bound (ELB). We show that policymakers who seek to minimize a (symmetric) quadratic loss function involving deviations of inflation and output from targets will achieve an average inflation rate below target due to the contractionary effects associated with hitting the ELB. We also characterize optimal discretionary policy for policymakers who view output losses as asymmetric: they place weight on the output gap when output is below potential but place little or no weight on the gap when output is above potential. In comparison to optimal policy using the symmetric loss function, the average inflation rate is higher and closer to the central banks target. Moreover, in response to contractionary demand shocks that push the nominal interest rate to the effective lower bound, policymakers with an asymmetric loss function adopt a policy rate path that remains at the ELB longer but eventually rises more quickly than the path adopted by a policymaker with a symmetric loss function.     

Inflationary expectations and monetary policy: evidence from Bangladesh

This article first estimates inflationary expectations using a Blanchard–Quah VAR model by decomposing the nominal interest rate into expected inflation and the ex ante real interest rate. Then I utilize this expected inflation along with other macroeconomic variables as inputs to the monetary policy function in a recursive VAR model to identify exogenous policy shocks. To calculate inflationary expectations, I assume that ex ante real interest rate shocks do not have a long-run effect on the nominal interest rate. This article finds that the public expects lower inflation for the future during periods of high inflation. Estimated results from the recursive VAR suggest that a contractionary policy shock increases the real interest rate, appreciates domestic currency, and lowers inflationary expectations and industrial output. However, I find a lagged policy response from Bangladesh Bank to higher inflationary expectations.     

Long run determinants and short run dynamics of inflation in Tunisia

The essential idea of this study is to analyse the origins of inflation at short and long runs in Tunisia relying on annual data during the period 1962 to 2003. We also suggest a model that has a structure determined by monetary and structural factors, and estimated by Johansen's cointegration technique. The empirical results show that inflation is explained by mixed factors: monetary ones such as money supply, the interest rate and the real effective exchange rate; and structural ones like the nominal average annual wage rate, the import prices and the real output. The analysis aims at pointing out the long run determinants of inflation and studying its short run dynamics.     

A note on the specification of the fisher equation under inflation uncertainty

The effect of uncertainty on the relationship between the nominal interest rate and the expected rate of inflation, the Fisher equation, is examined both theoretically and empirically. It is found that the coefficient of the expected rate of inflation is significantly below unity. Variable rates of inflation tend to effect the nominal rate of interest positively, but real yields are apparently effected only by expected inflation, but not its variance.     

Exchange Rate Stability, Inflation, and Growth in (South) Eastern and Central Europe

The authors analyze the impact of the exchange rate regime on inflation and output in (South) Eastern and Central Europe. For the whole observation period the estimations reveal a significant impact of exchange rate stability on low inflation as well as a highly significant positive impact of exchange stability on real growth. When subdividing the period into a "high-inflation" period (1994–97) and a "low-inflation period" (1998–2004), and when removing outliers from the sample, the evidence in favor of a positive association between exchange rate stability and inflation disappears. The association of exchange rate stability with higher real growth remains robust. These findings suggest that membership of the (South) Eastern and Central European countries in the European Monetary Union would have a positive impact on these countries' growth rates.     

Inflation and output growth uncertainty in individual survey expectations

This paper studies uncertainty using the ECB Survey of Professional Forecasters’ data. Both inflation and real GDP growth forecasts at the micro level are considered. Our analysis indicates that individual inflation uncertainty is closely related to output growth uncertainty. Individual forecasters seem to behave according to an uncertainty-augmented hybrid specification of the New Keynesian Phillips curve. We also find evidence that inflation uncertainty has a negative impact on economic activity by lowering output growth, boosting inflation and reducing the price-sensitiveness of aggregate supply.     

Monetary Policy, Nominal Interest Rates, and Long–Horizon Inflation Uncertainty

Empirical evidence presented in this paper shows that the predictability of inflation at long horizons varies considerably across countries. Both simple theory and empirical evidence suggest that the crucial factor is the extent to which systematic monetary policy succeeds in preventing a unit root in inflation. The mechanism by which it does this appears however to be complicated by strong empirical evidence that nominal as well as real interest rates have real effects, which implies that monetary policy need not be so vigorous in reactions to inflation. This helps to explain why inflation rates in the US and (especially) Germany have been relatively predictable, despite monetary policy rules which appear to have been barely stabilising. The paper also presents tentative evidence that the power of nominal interest rate effects is inversely related to long–horizon inflation uncertainty, and hence ultimately uncertainty about monetary policy.     

Does trend inflation make a difference?

Although the average inflation rate of developed countries in the postwar period has been greater than zero, much of the extensive literature on monetary policy has employed models that assume zero steady-state inflation. In comparing four estimated medium–scale NK DSGE models with real and nominal frictions, we seek to shed light on the quantitative implications of omitting trend inflation, that is, positive steady–state inflation. We compare certain population characteristics and the IRFs for the four models by applying two loss functions based on a point distance criterion and on a distribution distance criterion, respectively. Finally, we compare the RMSE forecasts and we consider also an indirect inference test. We repeat the analysis for three sub-periods: the Great Inflation, the Great Moderation and the union of the two periods. We do not find strong evidence that a model with trend inflation should always be preferred. During periods of high inflation or when a backward-looking component, indexed to past inflation, is not incorporated in the model, using a model that employs trend inflation can improve the analysis. Nevertheless, where there is uncertainty concerning the change of an inflation regime, such as the recent drop, we suggest adopting a traditional approach that does not use trend inflation.     

SOCIAL STATUS AND THE GROWTH EFFECT OF MONEY*

It has been shown that in a standard one‐sector AK model of endogenous growth with wealth induced preferences for social status, the economy's growth rates of real output and nominal money supply are positively related when the cash in advance constraint is applied solely to the household's consumption purchases. However, a positive output growth effect of money/inflation is not consistent with the existing empirical evidence. We show that when gross investment must be financed by real money balances as well, this result is overturned, i.e. higher inflation is detrimental to economic growth, because of a dominating portfolio substitution effect.