The Relationship Between Inflation And Inflation Uncertainty In Vietnam Over The Period 1995-2010.Pdf

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM NETHERLANDS PROGRAMME FOR M A IN DEVELOPMENT ECONOMICS THE RELATIONSHIP BETWEEN INFLATION[.]

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY IN VIETNAM

OVER THE PERIOD 1995-2010

BY

NGUYỄN VĂN DŨNG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, NOVEMBER, 2011

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY IN VIETNAM

OVER THE PERIOD 1995-2010

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

2.2 Theories about the inflation-inflation uncertainty relationship 7

2.4 Methods to test the causal relationship between inflation and inflation

3.1.3 Diagnostic tests for serial correlation, heteroskedasticity and ARCH effects

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List of Tables

Table 2.1: Early empirical studies about the inflation-inflation uncertainty relationship

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Table 2.2: Empirical studies about the inflation-inflation uncertainty relationship using the simultaneous estimation approach 20

Table 2.3: Empirical studies about the inflation-inflation uncertainty relationship using the two-step approach with symmetric GARCH models to estimate inflation uncertainty 21

Table 2.4: Empirical studies about the inflation-inflation uncertainty relationship using the two-step approach with the extensions of GARCH model to capture the asymmetric inflation uncertainty 22

Table 4.1: Unit root tests 35

Table 4.2: Lag selection of AR(p) process 36

Table 4.3: OLS estimation of AR(13) model 37

Table 4.4: AR(13)-(GARCH(1,1), TARCH(1,1), PARCH(1,1), EGARCH(1,1)) models 39

Table 4.5: Granger Causality Tests 46

List of Figures Figure 4.1: Descriptive statistics of inflation in Vietnam 1995-2010 34

Figure 4.2: Average rates of inflation by month in the period 1995-2010 (%) 34

Figure 4.3: Inflation uncertainty of the AR(13)-EGARCH(1,1) model 45

Figure 4.4: Inflation and inflation uncertainty over the period 1995-2010 46

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List of Acronyms

AIC: Akaike Information Criterion

AR: Autoregressive

ARCH: Autoregressive Conditional Heteroskedasticity

EGARCH: Exponential Generalized Autoregressive Conditional Heteroskedasticity GARCH: Generalized Autoregressive Conditional Heteroskedasticity

HQ: Hannan-Quinn criterion

OLS: Ordinary least squares

PARCH: Power Autoregressive Conditional Heteroskedasticity

SBV: State Bank of Vietnam

SC: Schwartz criterion

TARCH: Threshold Autoregressive Conditional Heteroskedasticity

UK: the United Kingdom

US: the United States of America

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Acknowledgement

I would like to express my sincere gratitude to my supervisor Dr Tu Van Binh who gave me valuable guidelines, comments, suggestions, and inspiration for the successful completion of this study Besides, his friendly and inspiring approach has given me a great deal of encouragements to overcome difficulties in the whole research process

I am also thankful to all lecturers and program administrators in the Vietnam – The Netherlands Program for M.A in Development Economics They gave me wonderful knowledge and help me kindly during the course

Last but not least, I would like to express my appreciation to my family, my friends who have given me a lot of support when I pursue my studies at the program

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Abstract

The study investigates the causal relationship between inflation and inflation uncertainty in Vietnam over the period 1995-2010 using the two-step procedure Inflation uncertainty is modeled by both symmetric model (GARCH(1,1)) and asymmetric models (TARCH(1,1), PARCH(1,1), EGARCH(1,1)) The results indicate that there exists an asymmetric impact of inflation shocks on inflation uncertainty, implying that a positive inflation shock induces higher inflation uncertainty, while a negative inflation shock induces lower inflation uncertainty Based on information criteria including AIC, SC, and HQ as well as diagnostic tests, AR(13)-EGARCH(1,1)

is considered the best model to model inflation uncertainty Then Granger causality tests are employed to test the causality between inflation and inflation uncertainty (estimated by the AR(13)-EGARCH(1,1) model) The results support that a rise in inflation significantly leads to more inflation uncertainty, which confirms the Friedman-Ball hypothesis; and increasing inflation uncertainty leads to more inflation, confirming the Cukierman-Meltzer hypothesis, which indicates an “opportunistic” State Bank of Vietnam The policy implication is that the monetary authorities have to keep inflation low, stable and predictable to eliminate the negative impact of inflation uncertainty

Key words: inflation, inflation uncertainty, relationship, GARCH models,

Granger causality tests

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Chapter 1: Introduction

1.1 Background of the Study

Vietnam experienced hyperinflation in the late 1980s (approximately 300%/year) and early 1990s (approximately 50%/year) due to bad weather, weak financial system, and especially poor governance of the authority The year 1995 marked an important turning point when hyperinflation was completely controlled and Vietnam began its deep international integration (i.e formally normalized diplomatic relations with the US and became the full member of ASEAN)

The years after 1995 witnessed the 1997-1998 Asian Financial Crisis and its consequences to the world prices and aggregate demand Because of the negative consequences of the crisis, both demand for Vietnamese goods and domestic demand declined This period was marked by low inflation with mild deflation in

2000 (-0.5%) despite rapid monetary and credit growth (approximately 40%/year) and VND’s sharp devaluation (approximately 36%) in the period 1997-

30-2003 (Nguyen & Nguyen, 2010)

After the period of stably low inflation, inflation began increasing sharply with 9.5% in 2004 When the negative impact of the Asian crisis declined, demand began to rise Demand increase and the rise of salary in both the public and FDI sector in 2003 pushed the prices to rise Additionally, supply shocks (due to bird flu and bad weather) contributed to the price increase The government considered supply shocks mainly responsible for inflation Food prices increased by 15.5% compared with the general inflation rate of 9.5% and inflation of non-food products was 5.2% in 2004 (Nguyen & Nguyen, 2010)

For the fear of increasing inflation, State Bank of Vietnam (SBV) implemented tightening monetary policy, making interest rates increase slightly, and fixed the exchange rate since 2004 The rigid management of exchange rate until late-2008 did not stabilize inflation as in the period 2000-2003 Inflation, after

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declining slightly in 2006, increased sharply to 12.6% in 2007 and up to 20% in

2008 (Nguyen & Nguyen, 2010)

There are many causes of high inflation in the period 2007-2008, which include the sharp increase of minimum wage rate, sharp rise of international commodity prices, lax and inflexible monetary policy, rigid exchange rate management, and the opening of Vietnam to the world economy since Vietnam’s join the WTO in late-2006, leading to indirect investment flows of foreign countries into Vietnam, pushed stock prices and asset prices increase dramatically To stabilize the exchange rate, SBV had to pump a large amount of money into the economy (approximately VND 145 thousand billion), contributing to more severe inflation In fact, the increase of money supply and credit growth in the economy in the last decade was very strong, especially in 2007 when M2 increased by 47% and credit growth increased by 54% (Nguyen & Nguyen, 2010)

Impacts of the 2007-2008 Global Financial Crisis made inflation slow down

in Vietnam since late-2009 The decrease of international prices and total demand made Vietnam reverse alarming trend of increased inflation since 2008 However, for fear of recessionary impacts, the government introduced the stimulus package since the second quarter of 2009, which made money supply and credit soar The early months of 2010 saw relatively stable inflation rates However, inflation increased sharply since September 2010 and reached 11.75% for the whole year

In general, the period 1995-2010 is the relatively stable inflation time compared with the hyperinflation period in the late 1980s-early 1990s Inflation is rather low in a decade from 1996 to 2006 However, high inflation has returned to the Vietnamese economy since 2007 with two-digit inflation rate, which poses many threats to the economy

1.2 Problem Statement

Inflation is a worldwide problem that causes a negative impact on every economy in the world In the Vietnamese case, the country incurred relatively high

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level of inflation during a long period 1995-2010, on average 7%/year, which is more persistent and more volatile than that of other countries in the Southeast Asia region Inflation may result in many serious consequences Among them, inflation uncertainty is regarded as one of the most significant consequences of inflation Inflation uncertainty is defined as a situation in which future price levels are unpredictable and the general public does not know whether inflation will increase

or decrease in the future As a result, it affects negatively consumers and producers’ decisions about saving and investment in the future, which leads to the loss of economic well-being (Golob, 1994) As a result, understanding the nature of the relationship between inflation and inflation uncertainty is essential for improving current policies to control inflation and stabilize the macro economy

1.3 Research Objectives

The specific objectives of the study are to

(i) examine whether there is an asymmetric impact of inflation shocks on inflation uncertainty in Vietnam

(ii) test whether inflation causes inflation uncertainty in Vietnam

(iii) test whether inflation uncertainty causes inflation in Vietnam

(iv) offer some policy implications to better control inflation and inflation uncertainty

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1.5 Research Hypotheses

The null hypotheses are as follows:

H0: Inflation does not cause inflation uncertainty

H0: Inflation uncertainty does not cause inflation

1.6 Justification of the Study

This study makes a major contribution in two aspects as follows

First, there have been many empirical studies on the relationship between inflation and inflation uncertainty However, most of the studies mainly focus on developed countries with relatively low inflation rates (Jiranyakul & Opiela, 2010) There are still few studies about this issue for developing countries with relatively high inflation rates In the case of Vietnam, there are still no published studies about this topic Therefore, this paper contributes to the literature as one of the first comprehensive analysis about this issue in the Vietnamese case

Second, the evidence from this study is informative and useful for monetary authorities so that they can understand the nature of the inflation-inflation uncertainty relationship in Vietnam during the past sixteen years empirically As a result, they have reliable foundation to propose and implement policies to control inflation better

1.7 Scope of the Study

The study will investigate the inflation-inflation uncertainty relationship in Vietnam during the period 1995-2010

1.8 Organization of the Study

The remaining of the paper is structured as follows: Chapter 2 gives a review

of definition, consequences, and methods to model inflation uncertainty In addition, theories, empirical studies about the inflation-inflation uncertainty relationship and methodology to test this relationship are also presented Chapter 3

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presents the research methodology Chapter 4 reports the findings and discussion Chapter 5 presents the conclusion, suggests some practical policy implications, and discusses the limitation and direction for further studies

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Chapter 2: Literature Review

2.1 Inflation Uncertainty

Definition

It is important to understand clearly the concept “inflation uncertainty”

before going further with the study Inflation uncertainty is defined as “a situation in

which future prices are unpredictable and general public does not know whether inflation will increase or decrease in the future In simple words future inflation rate

is fickle to public” (Asghar et al., 2011, p 86)

Economic consequences of inflation uncertainty

According to Golob (1994), inflation uncertainty affects the economy in two ways: ex-ante and ex-post effects

Ex-ante effects refer to the situation in which economic agents make economic decisions different from their decisions in the case of no inflation uncertainty There are three channels through which ex-ante effects transmit to the economy Firstly, inflation uncertainty makes long-term interest rates increase in the financial markets Secondly, inflation uncertainty makes other economic variables (future wages, future rents, tax rates) which are significant for the decisions of businesses become uncertain Lastly, inflation uncertainty induces businesses to spend large resources to avoid the risk of future inflation

Ex-post effects happen when inflation in reality is different from the expected one As a result, unexpected inflation causes a transfer of wealth among different sides when they use nominal money for the settlement of payments in the contract In particular, if inflation rises more than anticipated, the contract payments will be less than expected in terms of their real value

Why rising inflation may lead to an increase in inflation uncertainty

It is widely acknowledged that the Friedman-Ball hypothesis holds for all countries with different rates of inflation (discussed deeper in the empirical study

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section) The explanation for this relationship is that monetary policies may cause inflation uncertainty due to uncertainty about the timing and short-run effects of these policies on inflation

First, there is uncertainty about the timing of controlling-inflation policies due to short-run tradeoffs when implementing tightening monetary policy Although the central bank always aims at the long-run goal of controlling inflation, it may fear of the short-run downturn of the economy If inflation happens in the period of poor economic growth, it is uncertain which priority is: fighting inflation or supporting economic growth As a result, there is rising uncertainty about the time when the central bank implements contractionary monetary policy to lower inflation (Golob, 1994)

Second, as pointed out by Holland (1993), in the case of inflation, there is still uncertainty about the effect of monetary policy on inflation even though the tightening monetary policy is guaranteed Specifically, it takes time for the policy to transmit its impacts to the banking sector, then to the real economy, and finally to inflation Furthermore, it is difficult to estimate the extent of the price level’s response to the monetary policy Hence, the complicatedness of forecasting the speed and extent of the price level’s response to the monetary policy brings about inflation uncertainty (as cited in Golob, 1994)

2.2 Theories about the inflation-inflation uncertainty relationship

Friedman (1977) proposes a framework for the relationship between inflation and inflation uncertainty He forms an “informal two-part argument about the real effects of inflation” (as cited in Asghar et al., 2011, p 88) In the first part, when inflation increases, there will be political pressure from the public and voters that force policy makers to reduce inflation However, the policy makers may not implement contractionary monetary policy to lower inflation because of the fear of recessionary impacts As a consequence, the future monetary policy is unpredictable, which causes inflation uncertainty to increase in the future In the

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second part, Friedman argues that this increasing inflation uncertainty influences the economic growth of the country negatively (as cited in Thornton, 2007; Jiranyakul

& Opiela, 2010; Asghar et al., 2011)

Ball (1992) presents the first part of Friedman’s argument formally in the framework where the general public faces the asymmetric information about policy makers He categorizes two types of policymakers: tough and soft Tough policymakers are willing to disinflate However, the soft type is afraid of the recessionary effects of disinflation The public do not know exactly which type of policymakers will be in power, which causes uncertainty about future inflation Hence, the hypothesis presented by Friedman (1977) and Ball (1992) is named Friedman-Ball hypothesis in economic literature (as cited in Kontonikas, 2004; Nazar & Mojtaba, 2010)

On the other hand, the inflation-inflation uncertainty nexus is considered in the opposite direction by Cukierman and Meltzer (1986) They argue that an increase in inflation uncertainty leads to rising inflation The reason is that the monetary authority may take advantage of this inflation uncertainty to make inflation surprise (expansionary monetary policy) to stimulate economic growth This type of central bank is regarded as an “opportunistic” one (as cited in Fountas, Ioannidis & Karanasos, 2004; Thornton, 2007)

Holland (1995), in contrast to Cukierman and Meltzer (1986), argues that rising inflation uncertainty leads to lower inflation in the future The reason is that the central bank would like to minimize the welfare cost of more inflation uncertainty; thus it carries out tightening monetary policy to lower inflation uncertainty This type of central bank is considered a “stabilizing” one (as cited in

Thornton, 2007 Erkam & Cavusoglu, 2008)

For decades, there have been many empirical studies to examine whether rising inflation causes increasing inflation uncertainty (Friedman-Ball hypothesis), rising inflation uncertainty causes increasing inflation (Cukierman-Meltzer hypothesis), or rising inflation uncertainty causes lower inflation (Holland

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hypothesis) These studies use different methods and focus on different countries with different sample periods, frequency of data sets The following part reviews the methods to estimate inflation uncertainty from simple to more complex ones

2.3 Approaches to estimate inflation uncertainty

Engle (1982) is the first economist who develops Autoregressive Conditional Heteroskedasticity (ARCH) model to estimate inflation uncertainty He employs the standard inflation model as an Autoregressive - AR(p) The ARCH model is proposed to model and forecast the conditional variance The conditional variance is estimated on a time-varying basis In the ARCH model, the variance equation is a function of past squared forecast errors This variance can be used as a proxy for inflation uncertainty (as cited in Nazar & Mojtaba, 2010; Asghar et al., 2011)

Mean inflation equation

0 1

2 0

Where 0, j 0so that the conditional variance is positive

The disadvantage of the ARCH model widely pointed out in empirical studies is that it shows long lag processes of the squared forecast errors (Bollerslev, 1986) To model the persistent effect better, economists have developed some extensions of the ARCH framework Bollerslev (1986) introduces the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model, in particular the GARCH(1,1) model In the GARCH(1,1) model, the conditional variance is a function of past value of the forecast error and its own lagged value

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Where α0 > 0 1 0,  0so that the conditional variance is non-negative

α1+β <1 for a variance stationary model

However, Brunner and Hess (1993) argue that the ARCH and GARCH models impose symmetric restriction on the response of inflation uncertainty to inflation shocks, which seems to be “inconsistent with the Friedman’s hypothesis” Specifically, according to Friedman (1977), the inflation-uncertainty nexus is defined as “the higher the rate, the more variable it is likely to be”, which means that a rise in inflation causes more inflation uncertainty, while a fall in inflation leads to less uncertainty Meanwhile, the conventional ARCH or GARCH models

put the ε2 in the conditional variance equation, implying that positive shocks to inflation cause inflation uncertainty at the same extent as negative shocks; thus they bias the Friedman’s hypothesis (Rizvi & Naqvi, 2008; Jiranyakul & Opiela, 2010)

Therefore, some variations of the GARCH model are proposed to model the asymmetry characteristics of the conditional variance; three most popular ones are TARCH, PARCH and EGARCH models

Glosten, Jagannathan, and Runkle (1993) and Zakoian (1994) propose the threshold ARCH (TARCH) model which can capture the asymmetric effect of positive and negative shocks on volatility The specification of the TARCH(1,1) model is as follows