Inflation and inflation uncertainty in Turkey

Abstract

This article investigates the relationship between inflation and inflation uncertainty, and the impact of monetary policy on this relationship using monthly Turkish inflation data over January 1984 to–October 2005. The results from various types of GARCH-M models indicate that higher inflation rates lead to greater inflation uncertainty. On the other hand, the effect of inflation uncertainty on inflation is found to be negative due to stabilization motives’ dominating the opportunistic incentives of monetary authorities. We find strong evidence to support the view that inflation-oriented monetary policy has power to reduce the inflation persistence and eliminate uncertainty.

Notes

¹ There is no consensus on the terminology about inflation volatility and inflation uncertainty in the literature. In this article, we prefer using conditional variance of inflation as a measure for uncertainty. The interested reader should see Batchelor and Dua (1996) for a comparison of measures and proxies used for volatility and uncertainty.

² Although recent empirical studies mostly relied on GARCH type of models, some studies such as Grier and Perry (1998) and Nas and Perry (2000) used the two-step procedure. At first step, GARCH model of inflation is estimated and the conditional variance from this estimation is used as inflation uncertainty. Then, the Granger causality tests between inflation and generated inflation uncertainty series are performed at the second step. However, Pagan (1984) argues that the two-step procedure is inferior to simultaneous estimation. That is, if inflation affects inflation uncertainty then inflation uncertainty must enter into the GARCH model in the first step and if inflation uncertainty has impact on inflation then inflation uncertainty must be included into the inflation equation in the first step.

³ We follow the notation in Kontonikas (2004).