The relationship between inflation and inflation uncertainty in viet nam over the period 1995 2010

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 T

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY IN VIETNAM

OVER THE PERIOD 1995-2010

BY NGUYEN VAN DUNG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, NOVEMBER, 2011

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

By NGUYEN VAN DUNG

Academic Supervisor:

DR TU vAN BiNH

HO CHI MINH CITY, NOVEMBER, 2011

1.6 Justification of the Study

1 7 Scope of the Study

1.8 Organization of the Study

Chapter 2: Literature Review

2.4 Methods to test the causal relationship between inflation and inflation

3.1.4 Measuring inflation uncertainty

3 1.5 Granger causality tests

4.2 Unit root testing

4.3 OLS estimation of AR(p) model of inflation

4.4 Measuring inflation uncertainty

4.5 Granger causality tests

4 6 Comparison with previous studies

List of Tables

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

19

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 t fl t' rt t 22 asymme ric In a Ion unce ain y

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(l,l), 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

IV

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

v

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 The Netherlands Program for M.A in Development Economics They gave me wonderful knowledge and help me kindly during the course

Vietnam-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

Vl

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(l,l), PARCH(l,l), EGARCH(l,l)) 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(l,l)

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

Vll

Chapter 1: Introduction

1.1 Background of the Study

Vietnam experienced hyperinflation m 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 untillate-2008 did not stabilize inflation as in the period 2000-2003 Inflation, after

1

•

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

2

•

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

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

4

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

5

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 1s 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 section) The explanation for this relationship is that monetary policies may cause

6

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 second part, Friedman argues that this increasing inflation uncertainty influences the

7

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, 201 0)

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, Joannidis & 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 hypothesis) These studies use different methods and focus on different countries

8

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

Where a> 0, aj ;:::: 0 so that the conditional variance is positive

The disadvantage of the ARCH model widely pointed out m 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(l, 1) model In the GARCH(l, 1) model, the conditional variance is a function of past value of the forecast error and its own lagged value

GARCH (l,l)

(2) Where a0 > 0 a1 ;:::: 0,/];:::: 0 so that the conditional variance is non-negative

9

a 1 +~ <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 i 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

T ARCH, PARCH and EGARCH models

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

10

Another model to capture the asymmetric effect of positive and negative inflation shocks on volatility is the asymmetric power ARCH (PARCH) model proposed by Ding et al (1993) The specification of the PARCH(l,l) model is as follows

represents the power transformation parameter

Nelson (1991) proposes the EGARCH model which is preferable in investigating the asymmetric inflation-inflation uncertainty relationship The EGARCH(1,1) model is formulated as follows:

EGARCH( 1,1)

According to Nelson, the EGARCH process constructs the conditional

variance in logarithm (logh 1); thus even if the parameters are negative, h 1 in (5) is still positive Therefore, this specification overcome the requirement of artificially non-negative parameters in the GARCH model (as cited in Rivzi, 2008; Jiranyakul

& Opiela, 2010)

As shown in ( 5), y is considered the asymmetric or leverage term If r -::t: 0, the impact of inflation shocks on inflation uncertainty is asymmetric Specifically, when r is positive, a positive inflation shock leads to more inflation uncertainty and vice versa (Asghar et al., 2011) This explanation is also identical to Friedman's argument of inflation-inflation uncertainty nexus (Brunner & Hess, 1993)

11

2.4 Methods to test the causal relationship between inflation and

inflation uncertainty

There are commonly two approaches to test the causal relationship between inflation and inflation uncertainty in the literature The first one is the two-step approach The first step is to estimate the conditional variance by ARCH, GARCH

or variations of GARCH models, which is used latter as the proxy for inflation uncertainty Then Granger causality tests are performed to examine how the two variables related to each other There is a popular use of this approach in examining the inflation-inflation uncertainty relationship Some major studies include Fountas, Joannidis & Karanasos (2004), Daal, Naka & Sanchez (2005), Thornton (2007), Jiranyakul & Opiela (20 1 0), Asghar et al (20 11 ), etc

However, Pagan (1984) points out the problem with this two-step approach

is that generated variables in the first step are employed as the regressors in the second step Consequently, the standard errors in the Granger tests are biased, suggesting the biasness of Granger tests' results (as cited in Caporale & Kontonikas, 2009; Baharumshah, Hasanov & Fountas, 2011)

The second approach is the simultaneous estimation approach: estimating inflation and inflation uncertainty simultaneously using a bivariate GARCH-in-mean (GARCH-M) framework Specifically, we will integrate the conditional variance in the mean inflation equation and the inflation in the conditional variance equation Some major studies using this approach include Kontonikas (2004), Thornton (2008), Keskek & Orhan (2010), etc

This approach is considered more efficient than the two-step approach because it helps eliminate the issue of generated repressors (Pagan, 1984) Nevertheless, the disadvantage of this approach is that it does not permit the checking of impacts of lagged inflation on inflation uncertainty or vice versa, which

is supposed to last for several periods Consequently, this limits the possibility of finding the causality between the two variables (Fountas et al., 2004, Caporale &

Kontonikas, 2009, Jiranyakul & Opiela, 2010)

12

Following this method of study, Engle (1983) examines the US CPI in

1947-1979 using the similar ARCH framework A significant ARCH effect is found with inflation uncertainty being higher in 1970s than in 1960s Nevertheless the inflation uncertainty in these periods is relatively low compared with the 1940-1950 period Additionally, the inflation-inflation uncertainty nexus is still not found

Following Engle (1982), Engle (1983 ), Bollerslev ( 1986) applies the improvement of the ARCH model - GARCH model, in particular GARCH( 1, 1) model to estimate inflation uncertainty based on US CPI and US GNP deflator 1948Q2 - 1983Q4 He also finds a significant ARCH effect Even though the GARCH model is better at modeling US inflation data than the ARCH one, there is still no evidence for the inflation-inflation uncertainty relationship

Brunner and Hess (1993) point out two reasons why previous studies by Engle (1982), Engle (1982), and Bollerslev (1986) cannot find the inflation-inflation uncertainty relationship First, the degree of inflation is not included in the conditional variance model in these studies Second, they use symmetric ARCH and GARCH models which do not conform to Friedman-Ball hypothesis Although no

13

of inflation is positively related to its variability, affirming the hypothesis of Friedman-Ball

Another study employing the GARCH-M models is Fountas (2001) Using

UK inflation data from 1885 to 1998, he also finds strong confirmation of the Friedman-Ball hypothesis

Kontonikas (2004), employing British data from 1972 to 2002 and

GARCH-M, threshold GARCH-GARCH-M, and component GARCH-M models, provides evidence to support the Friedman-Ball hypothesis Furthermore, it is found that the implementation of an explicit inflation targeting helps to lower inflation constancy and long-run inflation uncertainty

Thornton (2006) uses the GARCH-M framework to examine the connection between inflation and uncertainty in South Africa during 1957M1-2005M9 The result shows a positive and significant link between inflation and uncertainty in South Africa during this period, which is in agreement with the Friedman's hypothesis Following the similar methodology, using the GARCH(1,1)-M model, Thornton (2008) claims that the Friedman hypothesis holds for Argentina during 1810-2005

Keskek and Orhan (2010), employing Turkish inflation series during 1984M1-2005M10 and different categories of GARCH-M models, find that

14

The second approach: two-step approach has been widely used in a great number of empirical studies for its advantages which have been mentioned above

In this study, I categorize the studies applying the two-step approach into two groups: the first one using ARCH or GARCH model with symmetric inflation uncertainty, the second one using some variations of the conventional GARCH model with asymmetric inflation uncertainty The reason for this distinction is the importance of modeling the asymmetric effects of inflation shocks on inflation uncertainty which has been explained in the previous section

The following section presents a brief summary of major studies usmg conventional ARCH and GACRH models with symmetric inflation uncertainty

Grier and Perry ( 1998) use the GARCH model to measure the inflation uncertainty in G7 countries from 1948 to 1993 The Granger causality test is employed to test the causal relationship between inflation and inflation uncertainty There is evidence for Friedman-Ball hypothesis in all the countries However, evidence for Cukierman-Meltzer hypothesis is mixed An increase in inflation uncertainty causes higher inflation in Japan and France, which is consistent with Cukierman-Meltzer hypothesis Meanwhile, rising inflation uncertainty leads to lower inflation in US, UK and Germany, which supports the Holland hypothesis

Thornton (2007) employs the GARCH ( q, v) model to generate the inflation uncertainty estimates of twelve emerging countries with different time periods ranging from the 1950s to 2000s Friedman-Ball hypothesis is supported in all twelve countries based on Granger test results Evidence for Cukierman-Meltzer hypothesis is found in Hungary, Indonesia, and Korea where increasing inflation

15

uncertainty causes average inflation rates to rise In the meanwhile, the Holland hypothesis is supported in Colombia, Israel, Mexico, and Turkey

In the following section, the symmetric restriction in the ARCH and GARCH models is treated with some variations of the conventional GARCH model to capture the asymmetric inflation uncertainty in the following major studies

Fountas et al (2004) investigate this relationship in six European countries (France, Germany, Italy, the Netherlands, Spain, and the UK) from 1960 to 1999 by both the two-step approach and the simultaneous estimation approach in an EGARCH-in-mean (EGARCH-M) framework For the first approach, the Granger tests show that the Friedman-Ball hypothesis is supported in all countries apart from Germany Nevertheless, apart from the UK, inflation uncertainty is found not to lead

to negative output impacts in other countries It indicates that the common European monetary policy may cause asymmetric real effects (output) through the channel of inflation uncertainty As for the relationship going from uncertainty to inflation, the results are less robust The Cukierman-Meltzer hypothesis is confirmed in Italy, Spain, and France Meanwhile, the Holland hypothesis holds in Germany and the Netherlands The second approach also confirms the Friedman-Ball hypothesis in all countries except the Netherlands and Germany, showing the consistency of the two approaches As for the relationship in the opposite direction, significant impacts

of inflation uncertainty on inflation are not found This result is reasonable because

it takes time for the effects of inflation uncertainty to materialize in inflation; thus it

is difficult to fairly examine this relationship in a contemporary model like EGARCH-M

Daal, Naka, and Sanchez (2005), using the power GARCH model, analyze the inflation-inflation uncertainty relationship in both developed (G7 countries) and emerging countries (Asian, Latin America, Middle East) They conclude inflation Granger-causes inflation uncertainty in most both developed and emerging countries, firmly confirming the Friedman-Ball hypothesis However, there is mixed evidence for causality running in the opposite direction

16

Erkam and Cavusoglu (2008) study the inflation-inflation uncertainty relationship in seven transitional countries (Ukraine (1997Ml-2007M5), Azerbaijan (1996Ml-2004M9), Armenia (1996Ml-2007M3), Georgia (1997Ml-2006M2), Kazakhstan (1997Ml-2007M5), Kyrgyz Republic (1997Ml-2007M4), and Russia (1997Ml-2007M4)) using various forms of ARCH and GARCH models In order to test the causal linkage, both Granger causality tests and Holmes-Button tests are employed The evidence for the Friedman-Ball hypothesis is found in Ukraine, Azerbaijan, Russia The Cukierman-Meltzer hypothesis is supported in Russia and Kyrgyz Republic The Holland hypothesis holds in Azerbaijan, which indicates the effective monetary stabilization policy of the central bank

As fo~ Asian countries, Payne (2009) employs the ARIMA-GARCH(l, 1) model to examine the inflation-inflation uncertainty relationship in Thailand during the period 1965Ml-2007M3 The results indicate that the execution of inflation targeting in Thailand since 2000 lowers the impacts of inflationary shocks on inflation volatility persistence Similar to previous studies, the Granger causality tests confirm the Friedman-Ball hypothesis Nonetheless, a rise in inflation uncertainty leads to a fall in inflation, supporting the Holland hypothesis

Another study applying the two-step framework to test this relationship for Asian countries is Jiranyakul and Opiela (2010) Using the data of monthly CPI in ASEAN-5 countries (Malaysia, Indonesia, the Philippines, Singapore, and Thailand) during the period 1970M01-2007M12 and the AR(p)-EGARCH(1,1) model, it is concluded that there is a significant support for both the Friedman-Ball and Cukierman-Meltzer hypothesis in all countries For Thailand's case, the Cukierman-Meltzer hypothesis is supported, not the the Holland hypothesis (as in Payne, 2009) irrespective of the similar time span It is the difference in the method

to model inflation uncertainty (ARIMA-GARCH model in Payne (2009) compared with the AR(p)-EGARCH(1,1) model in Jiranyakul and Opiela (2010) that produces the opposite results

17

Following the same methodology of Jiranyakul and Opiela (2010), Nazar and Mojtaba (20 1 0) find that positive shocks affect inflation uncertainty more than negative ones in Iran over the period 1959-2009 The Friedman-Ball hypothesis is strongly supported based on the Granger causality test results However, there is no evidence of the causality going from inflation uncertainty to inflation

A recent research about Asian case is Asghar et al (20 11 ) They investigate the inflation-inflation uncertainty relationship in Pakistan, India and Sri Lanka in the period 1980Q1-2009Q4 by the EGARCH framework The results demonstrate that positive shocks to inflation lead to more uncertainty in all three countries The bivariate Granger causality tests confirm a bi-directional inflation-inflation uncertainty relationship in these countries

In general, the Friedman-Ball hypothesis IS strongly supported in all countries at different level of development and with different methods to model inflation uncertainty However, the Cukierman-Meltzer hypothesis is not strongly supported, with mixed results in different countries and with different methods to model inflation uncertainty

The following tables summarize the above-reviewed empirical studies in a more visual way

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

inflation uncertainty

evidence is found for the inflation-inflation uncertainty relationship

Bollerslev (1986) US CPI and US GNP GARCH(1,1) A significant ARCH effect is found

There is still no evidence for 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

inflation uncertainty

Caporale and US CPI after the GARCH-M The magnitude of inflation is positively related to its variability,

F ountas (200 1) UK CPI 1885-1998 GARCH-M Strong evidence of the Friedman-Ball hypothesis is found

Component GARCH-M inflation constancy and long-run inflation uncertainty

Thornton (2006) South Africa CPI GARCH-M There is a positive and significant link between inflation and

agreement with the Friedman's hypothesis

Thornton (2008) Argentina CPI 181 0- GARCH(1,1)-M Increasing inflation leads to more inflation uncertainty, confirming

Keskek and Turkey CPI Different categories of Strong evidence of the Friedman-Ball hypothesis and Holland

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

inflation uncertainty

Grier and G7 CPI 1948-1993 GARCH The Friedman-Ball hypothesis holds in all the countries

Cukierman-Meltzer hypothesis

Rising inflation uncertainty leads to lower inflation in US,

UK and Germany, which supports the Holland hypothesis

Mexico, and Turkey

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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

inflation uncertainty

1960-1999 Daal, Naka, Developed (G7 PARCH Strong support for the Friedman-Ball hypothesis in all countries

CPI Erkam and 7 transitional ARCH, GARCH, The evidence for the Friedman-Ball hypothesis is found in

Kyrgyz Republic

The Holland hypothesis holds in Azerbaijan, which indicates the

22

.,

effective monetary stabilization policy of the central banlc Payne (2009) Thailand CPI ARIMA-GARCH( 1,1) The Granger causality tests confirm the Friedman-Ball hypothesis

The execution of inflation targeting in Thailand since 2000 lowers the impacts of inflationary shocks on inflation volatility

persistence

Jiranyakul and ASEAN-5 countries AR(p)-EGARCH(1,1) There is a significant support for both the Friedman-Ball and

Nazar and Iran CPI 1959-2009 AR(p )-EGARCH( 1, 1) The Friedman-Ball hypothesis is strongly supported

As ghar et al Pakistan, India and AR(p )-EGARCH( 1,1) Positive shocks to inflation lead to more uncertainty in all three

uncertainty relationship in these countries

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2.6 Conceptual Framework

The theories about the inflation-inflation uncertainty relationship are visualized in the following conceptual framework There are three main hypotheses about this relationship including Friedman(1977)-Ball(1992), Cukierman-Meltzer(l986), and Holland(l995) hypotheses Friedman(l977) and Ba11(1992) argue that increasing inflation leads to more inflation uncertainty In the meantime, Cukierman and Meltzer (1986) view the relationship in the opposite direction with more inflation uncertainty leading to more inflation Oppositely, Holland(1995) states that more inflation uncertainty leads to less inflation

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(expansionary monetary policy) to stimulate economic growth

2 7 Chapter Summary

The chapter has presented the definition and consequences of inflation uncertainty The theories about the inflation-inflation uncertainty relationship include three main hypotheses: Friedman(1977)-Ball(1992), Cukierman-Meltzer(l986), and Holland(l995) hypotheses These hypotheses view the causality between inflation and inflation uncertainty in different directions The ARCH framework is introduced to estimate inflation uncertainty Two approaches to test this relationship are also presented: two-step approach and simultaneous estimation approach In addition, empirical studies about the inflation-inflation uncertainty relationship are systematically presented

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