Time-varying Effect of Inflation Uncertainty

Inflation remains a major concern for every economy. High inflation is generally believed to be costly because it makes the price mechanism a less effective apparatus in allocating resources efficiently (Friedman 1977). One of the most remarkable macroeconomic developments over the past two decades has been a significant decline in inflation across a number of countries. It is agreed that the focus of monetary policy on price stability has been the main cause of disinflation in these countries (Greenspan 2004). Decisions regarding targeting the level of inflation or stabilising monetary policy requires knowledge about the linkage between inflation and its associated uncertainty. One of the most important costs of inflation is the uncertainty it creates about future levels of inflation. This uncertainty makes the decision-making of businesses and consumers more difficult and reduces the economic well-being (Golob 1994).

In the literature, there are divergent views on the relationship between inflation and its associated uncertainty. For instance, Friedman (1977) and Ball (1992) argue for causality pointing from inflation to inflation uncertainty, that is, higher inflation causes higher inflation uncertainty. The findings of Friedman and Ball were further substantiated by scholars like Brunner and Hess (1993), Grier and Perry (1998, 2000), and so on. Whereas, in several other contributions, the opposite causal relationship is suggested, that is, higher inflation uncertainty causes higher inflation like in Cukierman and Meltzer (1986). Holland (1995) postulated the opposite relationship, that is, higher inflation uncertainty leads to lower inflation under the assumption that monetary authorities try to minimise the welfare loss arising from higher inflation uncertainty.