Regime‐dependent effects of uncertainty on inflation and output growth: evidence from the United Kingdom and the United States
| Date | 01 September 2018 |
| DOI | http://doi.org/10.1111/sjpe.12168 |
| Published date | 01 September 2018 |
| Author | Kushal Banik Chowdhury,Srikanta Kundu,Nityananda Sarkar |
REGIME-DEPENDENT EFFECTS
OF UNCERTAINTY ON INFLATION
AND OUTPUT GROWTH: EVIDENCE
FROM THE UNITED KINGDOM AND
THE UNITED STATES
Kushal Banik Chowdhury*, Srikanta Kundu** and Nityananda Sarkar*
ABSTRACT
Employing a bivariate regime switching model, this paper attempts to examine
the regime-dependent effects of inflation uncertainty and output growth uncer-
tainty on inflation and output growth. Using monthly data of the United King-
dom 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.
II
NTRODUCTION
In his Nobel address in 1977, Friedman argued that high and volatile inflation
inhibits economic growth. Since then studying the impacts of nominal and
real uncertainties on inflation and output growth has become one of the most
important topics in macroeconomics. However, at the theoretical level, there
is a lack of consensus regarding the nature of these effects. Considerable
ambiguity surrounds the effects of inflation uncertainty on inflation and out-
put growth [see, for details, Friedman (1977), Cukierman and Meltzer (1986),
Holland (1995), and Dotsey and Sarte (2000)]. The economic mechanisms
involved in such relationships justify both negative and positive links. Similar
is the case regarding impacts of output growth uncertainty on inflation and
economic growth [see, Keynes (1936), Taylor (1979), Black (1987), Devereux
(1989), Bernanke (1983), Pindyck (1991) and Martin and Rogers (1995, 1997),
for details].
1
The existence of such apparently conflicting economic theories
has led many researchers to study these impacts empirically (see, for instance,
Grier and Perry (2000), Fountas et al. (2002), Grier et al. (2004), Elder
*Indian Statistical Institute
**Centre for Development Studies
1
See, Fountas et al. (2006), Fountas and Karanasos (2007) and Conrad and Karanasos
(2015) for details on these theories.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12168, Vol. 65, No. 4, September 2018
©2018 Scottish Economic Society.
390
(2004), Shields et al. (2005), Fountas et al. (2006), Wilson (2006), Fountas
and Karanasos (2007), Bredin and Fountas (2005, 2009), and Conrad and
Karanasos (2015)). However, the empirical evidence has also failed to yield
any clear outcome.
It is worth mentioning that all the empirical studies stated above typically
assumed that the parameters involved in the underlying relationships are con-
stant over the entire sample period. This means that the causal links are
assumed to be stable over time. But this assumption may not hold often in
practice. In a recent study, Greenspan (2004) argued that most of the empiri-
cal models dealing with uncertainty typically require a large number of time
series observations, and these are very much prone to structural instability or
regime changes. Hence, it is not surprising that empirical findings strongly dis-
agree across time and countries.
2
Furthermore, several studies, including those
by Stock and Watson (1996), Caglayan and Filiztekin (2003), Arghyrou et al.
(2005), and Lanne (2006), have argued that social, economic, and political
changes are likely to make the macroeconomic relationships unstable, espe-
cially when the length of the time series is long enough.
It is, therefore, important to propose models involving macreconomic
uncertainties, inflation, and output growth where the modeling framework is
assumed to be neither linear nor stable over the entire time period. It is now
well-known that an important class of such models is the regime switching
models.
3
The issue of regime switching behavior of inflation while dealing with
inflation uncertainty was first addressed by Evans (1991), and later by Evans
and Wachtel (1993), Bhar and Hamori (2004), Chen et al. (2008), Chang and
He (2010), Chang (2012), and Chowdhury and Sarkar (2015). Their overall
conclusion is that proper attention needs to be paid to the consequences of
regime switches; otherwise, the models would seriously underestimate both the
degree of uncertainty of inflation and its impact. In the same line, Henry and
Olekalns (2002), Garc
ıa-Herrero and Vilarrubia (2007), and Andraz and
Norte (2013) have shown that real uncertainty affects output growth differ-
ently in different output growth regimes which are characterized by expansion
and contraction.
4
This study attempts to make a contribution to this literature. To be specific,
the objective of the study is to examine the impacts of nominal and real
uncertainties on inflation and output growth in the regime switching frame-
work. More explicitly, the paper intends to analyze (i) the asymmetric effects
2
It is due to the same reason that during the recent decades, policymakers have been con-
fronted with era specific challenges for conducting monetary policy (Greenspan, 2004). This
is also corroborated by the recent findings of Hartmann and Roestel (2013), where they have
found unanimity on the relationships between inflation, output growth, and respective uncer-
tainties for 34 countries including developed and emerging ones, over the period of 1990–
2010 which they referred as the era of low inflation policies of these countries.
3
Few recent studies [see, among others, McConnell and Perez-Quiros (2000), Kontonikas
(2004), and Fang and Miller (2008)] have documented structural breaks in analyzing the rela-
tionships between inflation (output growth) and its uncertainty.
4
Hnatkovska and Loayza (2004) have examined how the impact of real uncertainty on
output growth depends on policy variables like the level of economic and financial develop-
ment, trade openness, and institutional development.
INFLATION, OUTPUT GROWTH AND UNCERTAINTY 391
Scottish Journal of Political Economy
©2018 Scottish Economic Society
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