RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY: THE CASE OF SERBIA

Transcription

1 Yugoslav Journal of Operaions Research Vol 19 (009), Number 1, DOI:10.98/YUJOR M RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY: THE CASE OF SERBIA Zorica MLADENOVIĆ Faculy of Economics, Universiy of Belgrade, Belgrade Received: December 007 / Acceped: May 009 Absrac: The purpose of his paper is o examine he relaionship beween inflaion and inflaion uncerainy in he Serbian economy, being paricularly vulnerable o shocks in inflaion rae, during ransiion period Based on monhly daa several GARCH specificaions are esimaed o provide he measure for inflaion uncerainy. Derived variables are hen included ino VAR model o es for Granger-causaliy beween inflaion and is uncerainy. Models ha consider only permanen and ransiory componens of prices are also esimaed o invesigae he inflaion-uncerainy relaionship in he long and in he shor run. The main conclusion of he paper is ha high inflaion invokes high uncerainy, while high uncerainy negaively affecs he level of inflaion a long horizon. Keywords: GARCH model, inflaion rae, he Cukierman-Melzer hypohesis, he Friedman-Ball hypohesis, VAR model. 1. INTRODUCTION The cos of inflaion has been a subjec of subsanial ineres in macroeconomy. Given ha inflaion uncerainy represens one of he major sources of his cos, he relaionship beween inflaion and is uncerainy has araced considerable aenion of boh applied and heoreical macroeconomiss. The issue was firs brough up by Friedman [17] who, in his well-known Nobel Prize speech, argued ha increased inflaion has a poenial o creae nominal uncerainy ha subsequenly lowers welfare and possible oupu growh. Friedman s idea was laer formalized by Ball [3]. The relaionship beween inflaion and inflaion uncerainy was also considered in reverse direcion, such ha high inflaion uncerainy may induce higher average inflaion, as advocaed by Cukierman and Melzer [10], [11].

2 17 Z. Mladenović / Relaionship Beween Inflaion The relaionship beween inflaion and inflaion uncerainy has been invesigaed in a number of empirical papers, and in mos of hem he G7 and some Asian counries have been analyzed. However, he empirical resuls reached do no uniformly suppor eiher he Friedman-Ball or he Cukierman-Melzer poin of view. The purpose of his paper is o economerically find ou wha characerizes he inflaion-uncerainy relaionship in Serbia during he ransiion period Given he previous hisory of high and even hyperinflaion in Serbia, and he curren ransiion process whose success depends largely on low and sable inflaion rae, his economeric analysis may enable furher insigh ino he dynamic srucure of inflaion, is uncerainy and heir co-movemens. Inflaion rae based on consumer price index will be used. The permanen and ransiory componens of inflaion rae will be exraced o examine he inflaion-uncerainy relaionship a long and shor horizons. Apar from Serbia, some preliminary resuls for four oher Balkan counries will also be provided. The srucure of he paper is as follows. Secion shorly reviews he heoreical background of he inflaion-uncerainy relaionship, and he exising empirical resuls. Secion 3 discusses main mehodological issues. Secion 4 provides empirical resuls obained for he Serbian economy. Preliminary resuls for some oher Balkan counries are given in Secion 5. Secion 6 makes a summary.. THE THEORETHICAL BACKGROUND OF THE RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY The relaionship beween inflaion and inflaion uncerainy consiss of a woway causaliy. The one-way causaliy running from inflaion o is uncerainy is known as he Friedman-Ball hypohesis, while he causaliy running in opposie direcion, from inflaion uncerainy o inflaion, is aken as he Cukierman-Melzer hypohesis. As already emphasized, Friedman [17] was he firs o poin ou ha changes in inflaion may induce erraic responses of moneary auhoriies, which may lead o more uncerainy abou he fuure inflaion. This conjecure was formally jusified by Ball [3] who used he asymmeric informaion game model in which he public faces wo ypes of policy-makers ha differ in erms of heir willingness o bear he economic coss of reducing inflaion. Policy-makers sochasically alernae in office. Therefore, an increase in inflaion raises uncerainy abou he pah of he fuure inflaion, because i is no known how long i will be before he ough ype gain power and akes measures agains high inflaion. Causaliy ha runs from inflaion uncerainy o inflaion was firs discussed by Cukierman and Melzer [11]. This resul is derived from a game-heoreic model of FED behavior under he assumpion ha FED dislikes inflaion, bu is willing o simulae he economy growh by creaing inflaion surprises. Boh he policy-maker s objecive funcion and he money supply process are assumed o be random variables. Alhough he expecaions are raional, informaion is imperfec due o imprecise moneary conrol mechanism. As a resul, he public canno make correc inference on fuure inflaion. Consequenly, an increase in inflaion uncerainy raises he opimal average inflaion rae by making he incenive for he policy-makers o produce inflaion surprises. Hence, inflaion uncerainy has a posiive impac on inflaion. By conras, Holland [19] suggesed ha his link could be negaive, such ha high inflaion uncerainy reduces level of inflaion rae, due o he sabilizaion moive of he moneary auhoriies.

3 Z. Mladenović / Relaionship Beween Inflaion 173 The analysis of he inflaion-uncerainy relaionship is addiionally deepened when he decomposiion of inflaion ino is permanen and ransiory componens is aken ino accoun. As noed by Ball and Cecchei [4], inflaion may reac differenly o inflaion uncerainy in he long-run and in he shor-run. Vice versa, uncerainy may no be affeced in he same way by he permanen and he ransiory shocks of inflaion. This decomposiion may be relevan o evaluae he efficiency of moneary and fiscal policies, because he behavior of inflaion in he long-run is usually associaed wih he moneary policy, while he shor-run variaions are ofen due o changes in fiscal policy. Boh he Friedman-Ball and he Cukierman-Melzer hypoheses were frequenly esed in numerous empirical analyses. Among papers we were able o find here are more in favor of he Friedman-Ball view [1], [7],[8], [1], [16], [18], [], han hose ha do no suppor i [6], [9], [14], [0]. The validiy of he Cukierman-Melzer hypohesis has no been invesigaed as ofen, bu mos of he exising resuls do suppor his view [1], [], [8], [1]. 3. MAIN METHODOLOGICAL ISSUES There are hree key mehodological issues in he economeric modeling of inflaion-uncerainy relaionship. The firs one deals wih he measure of inflaion uncerainy. The second issue provides framework for making inference on direcion of causaliy beween inflaion and uncerainy. The hird issue considers approach followed o obain permanen-ransiory decomposiion of inflaion. Some sandard measure of inflaion variabiliy is ofen used o approximae is uncerainy. However, here could be a significan difference beween variabiliy and uncerainy of inflaion depending on wheher he variabiliy is predicable in he model under consideraion [18]. Therefore, he class of generalized auoregressive condiional heeroskedasiciy models (GARCH models) emerges as a naural framework for his analysis for a leas wo reasons [6], [18], [4]. Firsly, GARCH models explicily specify and esimae he variance of he unpredicable innovaion in inflaion. Secondly, based on GARCH models a ime-varying condiional residual variance ha is in accordance wih he noion of uncerainy discussed in heoreical papers may be derived [18]. We will shorly overview GARCH models used in our empirical work. The simple GARCH (1,1) model reads as follows [6], [13], [4]: p m π = β + βπ + δ D + ε, ε = σ u, u : iid N(0,1) 0 i i j j i= 1 j= 1 σ = α + α ε + α σ, α > 0, α 0, α 0, α + α < (3.1) Mean equaion for inflaion, π, is expressed in he form of auoregressive model of order p in which dummy variables D j, j = 1,,m, may be included o capure he effecs of ouliers. Volailiy equaion describes condiional variance, σ, of an error erm ε, as a funcion of is own lagged-one value and he lagged-one value of he squared error erm ε. Parameers of he model are: β0, β1,..., βp, δ1,..., δm, α0, α1, α.

4 174 Z. Mladenović / Relaionship Beween Inflaion Among differen modificaions of GARCH models suggesed in he lieraure he power GARCH model (PGARCH model) was also applied in our empirical analysis. The PGARCH (1,1) specificaion gives he volailiy equaion of he form: η η η σ = α + α ε + α σ, α > 0, α 0, α 0, α + α < 1, η > 0. (3.) PGARCH model allows for he explici esimaion of powerη. Under he resricion η = 1, he condiional sandard deviaion is modeled wihin he volailiy equaion. This is he case of resriced PGARCH model. Parameers of GARCH and resriced PGARCH models are esimaed by he mehod of maximum likelihood. In pracice, he maximum of he likelihood funcion is found by he sandard numerical opimizaion mehods, among which he BHHH algorihm is he mos commonly implemened [15], [4]. Esimaed condiional variance ( ˆ σ ) from GARCH model or condiional sandard deviaions ( ˆ σ ) from resriced PGARCH model are aken as a measure of uncerainy [18]. In order o assess a direcion of causaliy beween inflaion and is uncerainy he use of vecor auoregressive model (VAR model) has been advocaed in he lieraure. This is one of he mos popular specificaions in macroeconomeric analysis, since i compleely capures dynamic srucure among variables of ineres. VAR model of order k beween inflaion and inflaion uncerainy derived from GARCH specificaions is posulaed in he following way: k k ˆ = a10 + a1i i + b1 j j + e1 i= 1 j= 1 π π σ k k = a0 + ai i + b j j + e i= 1 j= 1 ˆ σ π ˆ σ, (3.3) and e1 and e are Gaussian whie noise processes uncorrelaed a lags differen from zero. The Friedman-Ball hypohesis of causaliy running from inflaion o uncerainy canno be rejeced if inflaion Granger-causes uncerainy. This causaliy implies ha he null hypohesis, H0 : a1 = a =... = ak = 0, esed agains he alernaive ha he null is no rue, canno be acceped. The Cukierman-Melzer hypohesis of causaliy semming from inflaion uncerainy o inflaion can be acceped if he null hypohesis, H0 : b11 = b1 =... = b1 k = 0, esed agains he alernaive ha his null hypohesis is no valid, can be refued. This means ha uncerainy Granger-causes inflaion. If his is he case, hen he sign of he k sum b1 j shows wheher inflaion uncerainy leads o increase or decrease in he level j= 1 of inflaion rae. Decomposiion of ime series ino is permanen and ransiory componens can be done in differen ways. In his paper we follow he Beveridge-Nelson approach [5] based on he one of he key resuls from he uni-roo lieraure ha ime-series wih a uni-roo can always be represened as a sum of permanen and ransiory componens. Permanen componen accouns for he sochasic rend and hus explains he behavior in

5 Z. Mladenović / Relaionship Beween Inflaion 175 he long-run. Transiory componen is saionary and conains irregular variaions. The Beveridge-Nelson approach is underaken as follows [13]. The inflaion is firs esimaed by ARIMA specificaion on given sample of size T. Using esimaed parameers and insample forecass of prices in periods T and T-1 forecas errors in periods T and T-1 are derived. The combinaion of esimaed parameers and forecas errors enables esimaion of irregular componens for periods T and T-1. The replicaion of he same procedure for each observaion in he sample recovers he ransiory componen of prices, which is hen used o derive permanen componen direcly. 4. EMPIRICAL RESULTS 1 Monhly consumer price index (CPI index, 001=100) in Serbia is considered for he period: June, 001 June, 007 (73 observaions). Daa are obained from he following inerne addresses: and Inflaion rae is calculaed as he firs difference of he logarihm of CPI ( π = log CPI log CPI 1 = Δ log CPI ). Consumer price index has a srong upward rend which is described by he uni-roo presence, while inflaion rae appears o be saionary, bu wih he several ouliers due o changes in economic policy (Graph 4.1). 5.4 Consumer price index (log values).04 Inflaion rae Graph 4.1 Consumer price index and inflaion rae One of he key feaures of ime series in ransiion economies is he presence of srucural breaks. They should be aken ino accoun, because if hey are negleced, hen misleading saisical and invalid economic conclusions may be drawn [1]. Ouliers in he level of inflaion rae in Serbia occurred due o he following evens: he adminisraive change of he price of elecriciy in July, 00; he adminisraive change of communal uiliy prices in December 004; he inroducion of VAT in January, 005 and of inflaion argeing in Sepember, 006. The effecs of hese inervenions are eliminaed from inflaion rae by including appropriae impulse dummy variables ha ake only non-zero value one for he monh in which he change was deeced. Such ime series, which is correced for ouliers, is a subjec of economeric analysis in his paper. Ordinary (AC) and parial auocorrelaion (PAC) funcions are esimaed in order o discover dynamic srucure in he mean and variabiliy of inflaion rae. Values 1 All empirical resuls are obained using sofware EVIEWS 6.0 [15] and WINRATS 6.0 [3].

6 176 Z. Mladenović / Relaionship Beween Inflaion repored in Table 4.1 sugges ha mean equaion should probably conain auoregressive componens up o order wo. Also, variabiliy appears o be unsable, which jusifies he applicaion of GARCH specificaion. Table 4.1 The correlaion srucure of he inflaion mean and variance Lag Inflaion rae AC PAC Squared inflaion rae AC PAC Noe: The 95% confidence inerval is [-0.3; 0.3]. Following PGARCH(1,1) models give he mos saisfacory resuls: Model I: ˆ π = π π 1 (0.001) (0.070) (0.09) ˆ σ = ε σ 1 1 (0.0005) (0.113) (0.191) JB = 5.33(0.07), ARCH(4) = 3.0(0.53), Q(1) = 6.69(0.76), Q (1) = 13.15(0.), L = Model II: ˆ π = π π 1 (0.001) (0.081) (0.030) ˆ σ = ε σ π (0.0003) (0.091) (0.134) (0.019) JB = 4.60(0.10), ARCH(4) = 3.61(0.46), Q(1) = 5.98(0.8), Q (1) = 14.34(0.16), L = (4.1) (4.) Noe: The BHHH algorihm is used in he esimaion. The Bollerslev-Wooldrige sandard errors are calculaed and given in (.) below he coefficien esimaes. The mean equaion conains dummy variables previously inroduced. The following es-saisics are repored: JB is he Jarque-Bera es-saisic for normaliy of he residuals ha under he null of normaliy has χ () disribuion; ARCH(4) is he Lagrange muliplier es saisic for esing he fourh-order auocorrelaed squared residuals ha under he null of no auoregressive heeroskedasiciy has χ (4) disribuion; Q(1) is he Box-Ljung essaisic for he residual auocorrelaion of order 1 ha under he null of no serial

7 Z. Mladenović / Relaionship Beween Inflaion 177 correlaion has a χ (9) disribuion and Q (1) is he Box-Ljung es-saisic for auocorrelaed squared residuals ha under he null of no auoregressive heeroskedasiciy also has a χ (9) disribuion. The p-values are repored in (.) afer a saisic. L denoes he final log-likelihood funcion value. In Graph 4. mean inflaion and uncerainy derived from model II are depiced. Mean inflaion is approximaed well by his model. Esimaed volailiy exhibis insabiliy over ime, and is surge seems o coincide wih he increase in he level of inflaion rae Inflaion rae Inflaion rae approximaed by model II Uncerainy esimaed by model II Graph 4. Esimaed mean inflaion and volailiy from Model II To deermine in which way he causaliy beween inflaion and is uncerainy runs he VAR models of inflaion and inflaion uncerainy, derived from esimaed GARCH specificaions, are posulaed and esimaed. The resuls of he Grangercausaliy ess are repored in Table 4.. These resuls uniformly sugges one-way causaliy semming from inflaion o uncerainy. Hence, he Friedman-Ball hypohesis can be acceped as valid, while he Cukierman-Melzer hypohesis canno. This finding is suppored by he specificaion (4.) in which inflaion lagged-one period appears as significan explanaory variable in volailiy equaion.

8 178 Z. Mladenović / Relaionship Beween Inflaion VAR model beween inflaion and uncerainy Ho: Inflaion does no Granger-cause uncerainy Ho: Uncerainy does no Granger-cause inflaion Model I Model II k=1.99(0.08) 0.96(0.33) k= (0.04) 7.40 (0.1) k= (0.00) 1.81 (0.18) k= (0.00) 6.86 (0.14) Table 4. Granger-causaliy es beween inflaion and is uncerainy Noe: The number of lags (k) in VAR model is chosen using informaion crieria and saisical properies of he model. VAR conains some of dummy variables discussed above ha were needed o obain normally disribued residuals. This is a vial assumpion for he reliabiliy of he Granger-causaliy es repored in he form of χ (k) saisic wih p-value given in parenhesis. To find ou how robus our resuls are o he behavior of inflaion in he long and shor run, he permanen-ransiory decomposiion of prices (log) is obained under he assumpion ha is firs difference, inflaion, follows auoregressive process of order wo. Boh componens are depiced ogeher wih he prices in Graph 4.3. We may noice a similar paern of prices and is permanen componen, while heir difference, being a ransiory componen, describes only he shor-run variabiliy of prices. The firs difference of permanen and ransiory componens represens permanen and ransiory inflaion respecively (Graph 4.4). These wo ime series are considered separaely. The resuls of modeling permanen inflaion will be given in deail, while he findings for ransiory inflaion will be briefly summarized. 5.4 Consumer price index (log) 5.4 Permanen componen.006 Transiory componen Graph 4.3 Consumer price index, is permanen and ransiory componens

9 Z. Mladenović / Relaionship Beween Inflaion Inflaion rae Permanen inflaion rae Transiory inflaion rae Graph 4.4 Inflaion rae, permanen and ransiory inflaion rae Three GARCH specificaions are used in order o explain he behavior of permanen inflaion. These are: resriced PGARCH(1,1) model, resriced PGARCH(1,1) model wih permanen inflaion lagged-wo period in volailiy equaion and GARCH(1,1) model wih permanen inflaion lagged-wo period in volailiy equaion. Esimaes are given below: Resriced PGARCH(1,1) (Model of permanen inflaion I): ˆ π = π π p p 1 p (0.001) (0.081) (0.050) ˆ σ = ε σ. 1 1 (0.0004) (0.091) (0.174) (4.3) Resriced PGARCH(1,1) wih permanen inflaion lagged-wo period (Model of permanen inflaion II): ˆ π = π π p p 1 p (0.001) (0.089) (0.05) ˆ σ = ε σ π p. (0.0003) (0.086) (0.153) (0.008) (4.4) GARCH(1,1) wih permanen inflaion lagged-wo period (Model of permanen inflaion III): ˆ π = π π p p 1 p (0.001) (0.094) (0.059) ˆ σ = ε σ π p (0.0000) (0.118) (0.18) ( ) (4.5)

10 180 Z. Mladenović / Relaionship Beween Inflaion Noe: π p denoes permanen inflaion. The BHHH algorihm is used in esimaion. The Bollerslev-Wooldrige sandard errors are calculaed and given in (.) below he coefficien esimaes. The mean equaion conains dummy variables previously inroduced. Models do no show he signs of misspecificaion as confirmed by various specificaion ess repored in Table 4.3. All hree models provide similar resuls: he esimaes of he mean equaion do no differ significanly, while volailiy equaions capure almos idenical effecs of explanaory variables. Neverheless, o make resuls more reliable we use all hese models o generae uncerainy needed for Grangercausaliy esing. Model Q(1) Q (1) JB ARCH(4) L I 5.9(0.8) 1.6(0.5) 4.9(0.09) 3.0(0.54) II 6.0(0.8) 14.5(0.15) 4.8(0.09) 4.3(0.37) III 5.4(0.89) 14.1(0.17) 5.1(0.08) 4.1(0.40) Table 4.3 Specificaion ess for esimaed models of permanen inflaion Noe: Tes-saisics are explained in noe below equaion (4.). The resuls of he Granger-causaliy es beween permanen inflaion and associaed uncerainy are presened in Table 4.4. The resuls srongly suppor causaliy running from permanen inflaion o is uncerainy, suggesing ha he Friedman-Ball hypohesis is relevan for he long-run inflaion as well. There is some supporing evidence of causaliy running from uncerainy o permanen inflaion. In he wo models he null hypohesis ha uncerainy does no Granger-cause permanen inflaion canno be rejeced for p-values greaer han 8%. When sandard inflaion rae was considered he corresponding p-values were beween 1% and 33% (Table 4.). Thus, we may conclude ha he Cukierman-Melzer hypohesis has some empirical conen for he permanen inflaion in Serbia. The sum of esimaed coefficiens on lagged uncerainy in he equaion for permanen inflaion is negaive. This implies ha inflaion uncerainy has a negaive impac on he level of inflaion a long horizon. Since he behavior of prices in he long-run is primarily deermined by moneary policy, we may argue ha moneary policy in Serbia has been relaively efficien during period of VAR model of order 4 Ho: Permanen inflaion does no Granger-cause uncerainy Ho: Uncerainy does no Granger-cause permanen inflaion Model I (0.00) 7.73 (0.10) Model II 5.73 (0.00) 8.7 (0.08) Model III (0.00) 8.37 (0.08) Table 4.4 Granger-causaliy es beween permanen inflaion and is uncerainy Noe: See noe below Table 4..

11 Z. Mladenović / Relaionship Beween Inflaion 181 Transiory inflaion was modeled wihin a similar framework. Only one-way causaliy is deeced, semming from shor-run inflaion o is uncerainy. In he shor-run higher inflaion invokes higher uncerainy, bu uncerainy does no influence he inflaion significanly. Tenaively speaking, fiscal policy, responsible for he shor-run variaion in prices, has no been as efficien as moneary policy in sabilizing level of inflaion. 5. PRELIMINARY ANALYSIS FOR SOME OTHER BALKAN COUNTRIES Some Balkan counries have experienced high inflaion in recen hisory suggesing sensiiviy of heir economies o shocks in prices. Thus, he issue of inflaionuncerainy relaionship seems o be economically relevan for he whole Balkan region. We empirically invesigaed he dynamics of mean and volailiy of monhly inflaion raes in Bulgaria, Greece, Romania and Turkey for he period: January, 001 Ocober, 006. The daa are aken from IFS CD-ROM Version Table 5.1 summarizes he basic descripive saisics and he resuls reached. Counry Average Sandard Maximum Minimum Causaliy inflaion rae deviaion value value deeced Bulgaria No causaliy found Greece No causaliy found Romania From inflaion o uncerainy Turkey In boh direcions Table 5.1 Descripive saisics (of inflaion in %) and resuls of Granger-causaliy es We have no deeced unsable he variabiliy of inflaion in Bulgaria and Greece. However, a ime-varying uncerainy of inflaion found in Romania and Turkey was well capured by a simple ARCH(1) model. Furhermore, one way causaliy running from inflaion o is uncerainy is deermined for Romania, and in boh direcions for Turkey. Our analysis of he Turkish inflaion parly concurs wih he findings previously repored for a differen sample [1], []. Alhough his is jus a preliminary sudy, resuls obained so far highligh he imporance of invesigaing he inflaion-uncerainy relaionship in he Balkan region. 6. CONCLUSION This paper employs sandard approach of GARCH modeling and VAR seup o consider he relaionship beween inflaion and inflaion uncerainy in Serbia in he period The novely inroduced in his sudy is he applicaion of he Beveridge-Nelson decomposiion of prices in order o find ou wha characerizes his relaionship in he long and shor run. There is a srong evidence of causaliy running

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