Has the 2008 financial crisis and its aftermath changed the impact of inflation on inflation uncertainty in member states of the european monetary union?
| DOI | http://doi.org/10.1111/sjpe.12170 |
| Published date | 01 May 2019 |
| Date | 01 May 2019 |
| Author | Nima Nonejad |
HAS THE 2008 FINANCIAL CRISIS AND
ITS AFTERMATH CHANGED THE
IMPACT OF INFLATION ON
INFLATION UNCERTAINTY IN
MEMBER STATES OF THE EUROPEAN
MONETARY UNION?
Nima Nonejad*
ABSTRACT
We study to what extent the financial crisis of 2008 and its aftermath have
changed the impact of inflation on inflation uncertainty in the 12 original mem-
ber states of the European Monetary Union (EMU). We adopt a time-varying
coefficient regression model with stochastic volatility effects, and extract two
measures of inflation uncertainty from our data, namely, (1) The conditional
volatility of inflation, (2) The conditional volatility of steady-state inflation.
(1)–(2) represent short-run and steady-state inflation uncertainty, respectively.
The time-varying impact of inflation on inflation uncertainty is analyzed using
Markov-switching regressions, where switching between the low and high infla-
tion uncertainty regime is determined via an unobserved Markov process. Results
suggest that the 2008 financial crisis and its aftermath have changed the impact
of inflation on (1) and (2) across the selected EMU member states. However, a
uniform pattern cannot be detected. For some member states, we document a
strong link, whereas for others, the impact of inflation on inflation uncertainty is
relatively weaker.
II
NTRODUCTION
Over the past three decades, two major events have had important ramifica-
tions on the European Economic Community (EEC), namely, introduction of
the euro in 1999, and the financial crisis of 2008, which has subsequently
resulted in the sovereign debt crisis. The former event represents a major pol-
icy shift for member states in the European Monetary Union (EMU), which
can have important implications on inflation, inflation expectations, and infla-
tion uncertainty. For example, Feldstein (2005) argues that formation of a
monetary union can increase inflation uncertainty for the entire union due to
a free-rider problem if individual member states simultaneously retain their
*Aalborg University and CREATES
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12170, Vol. 66, No. 2, May 2019
©2018 Scottish Economic Society.
246
fiscal authorities. In such instances, large budget deficits in individual member
states can put pressure on the central bank in charge of monetary policy for
the entire monetary union to inflate. As argued in Davig et al. (2011), this can
ultimately increase inflation and inflation uncertainty as it becomes unclear to
what degree the central bank can resist pressures to inflate, or reverse already
implemented inflationary policy. The latter event represents a major economic
shock that evidently creates uncertainty regarding future inflation rates. It also
creates additional uncertainty (within the monetary union) with regard to
responses and implications of policies conducted by the central bank currently
in charge of monetary policy for the entire union in times of economic tur-
moil.
Accordingly, understanding the impact of inflation on inflation uncertainty,
and its implications on economic activity is of great interest to European pol-
icy makers for a number of reasons: First, any evidence that inflation causes
inflation uncertainty with possible adverse output effect undoubtedly strength-
ens the price stability objective of the European Central Bank (ECB).
1
Second, according to Fountas et al. (2004), under (1) A common monetary
policy, where the aim is to achieve a uniform inflation rate across the member
states, and (2) The assumption that the interaction between inflation and out-
put takes place through the inflation uncertainty channel, any heterogeneity
(in the sense that the impact of inflation on inflation uncertainty, and the
effect of inflation uncertainty on growth differs across individual member
states) can result in asymmetric real effects (given the single nominal interest
rate). In other words, inflation reduction (e.g., due to contractionary mone-
tary policy) can increase aggregate output in some member states, but reduce
output in others. As argued in Fountas et al. (2004), policy makers are inter-
ested in determining if the impact of inflation on inflation uncertainty and
aggregate output is uniform across the EMU member states (and if so to
what degree) or not. In the latter case, a common monetary policy can
become less effective in terms fighting inflation and dealing with national
disparities.
Third, as mentioned in Arnold and Lemmen (2008), the lack of monetary
policy within the EMU can help explain why inflation uncertainty is higher in
some member states while lower in others. Particularly, in a monetary union
such as the EMU, the central bank tends to focus on average economic condi-
tions for the union as a whole, and attempts to ignore national idiosyncrasies
as much as possible. Accordingly, when the EMU is subject to inflation
shocks, larger member states that have a larger weight of aggregate inflation
can rely more firmly on price stability objectives of the ECB. Agents in smal-
ler countries are, however, more uncertain with regard to when inflation
increases will be reversed. According to Arnold and Lemmen (2008), this is
due to a combination of two effects, namely, imperfect information on the
1
According to the Maastricht Treaty, the primary objective of the ECB is price stability,
interpreted as an annual eurozone inflation rate below, but close to 2% in the medium-run.
However, according to the treaty, ECB should also be concerned with output and employ-
ment (while being compatible with its main objective), see European Central Bank (2004).
INFLATION, INFLATION UNCERTAINTY IN EMU 247
Scottish Journal of Political Economy
©2018 Scottish Economic Society
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