Low Inflation vs. Stable Inflation: Evidence from the UK, 1688–2009
| Published date | 01 November 2015 |
| DOI | http://doi.org/10.1111/sjpe.12090 |
| Author | Georgios Karras |
| Date | 01 November 2015 |
LOW INFLATION VS. STABLE
INFLATION: EVIDENCE FROM THE
UK, 1688–2009
Georgios Karras
ABSTRACT
This paper investigates the relationship between inflation and inflation volatility.
Using annual data from 1688 to 2009, the results show that UK inflation and its
volatility have been positively correlated when inflation exceeds a certain value,
but negatively correlated when inflation is below this threshold. The evidence
also suggests that the break in the relationship occurs between annual inflation
rates of 0.6% and 5.5%, which includes both the 2% inflation target of many
central banks, and the 3.5% break point predicted by the New Keynesian model
of Coibion et al. (2012).
II
NTRODUCTION
The relationship between inflation and its volatility plays a central role in
important macroeconomic questions involving monetary policy and the costs
of inflation. Despite the scarcity of theoretical models explaining this relation-
ship,
1
there is widespread consensus that the level of inflation and inflation
volatility are strongly and positively correlated. Originally, the positive rela-
tionship was considered mostly at higher inflation rates, as in Friedman
(1977). Gradually, however, the positive correlation was extended to apply to
moderate or even low inflation rates (for example, Taylor, 1981; Ball and
Cecchetti, 1990; Brunner and Hess, 1993; Grier and Perry, 1998; Davis and
Kanago, 1998, 2000; Fountas, 2001; Daal et al., 2005; Thornton, 2007; Kiley,
2007; D’Agostino and Surico, 2012), so that eventually the relationship has
come to be thought of as monotonic. Put simply, high inflation is generally
expected to be variable inflation, while conversely low inflation is generally
expected to be stable inflation.
Recently, however, Coibion et al. (2012) have presented a theoretical New
Keynesian model that not only endogenously generates a relationship between
the level and volatility of inflation, but also predicts that this relationship is
not monotonic. In particular, their model predicts that the relationship
University of Illinois at Chicago
1
Ball (1992) and Kiley (2007) provide two influential exceptions.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12090, Vol. 62, No. 5, November 2015
©2015 Scottish Economic Society.
505
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