Examining the inter-temporal dynamic relationship between inflation and volatility of inflation: evidence from Sri Lanka

Abstract

Introduction

Knowledge about the linkage between inflation and inflation variability (uncertainty) plays an important role in decision making of economic agents. Inflation volatility/uncertainty distorts decisions regarding future saving and investment due to reduced predictability of the real value of future nominal payments; further, it also extends the adverse effects of these distortions on the efficiency of resource allocation and the level of real activity (Fischer 1981; Golob 1993; Holland 1993). The welfare costs of inflation and inflation uncertainty are well documented in the literature. However, empirical evidence on the link between the two is sparse in the case of Asia and Sri Lanka in particular.

Inflation is defined as a persistent increase in the general price level, while inflation uncertainty refers to a situation in which future prices are unpredictable and the public does not know whether inflation will increase or decrease in the future. The existence of a positive association between the level and variability of inflation has been widely accepted in the literature (Okun, 1971; Logue and Willet, 1976; Foster, 1978; Taylor,1981). The link between inflation rate and inflation uncertainty attracted more attention by theoretical and empirical macroeconomists following the Nobel lecture of Friedman (1977). Friedman’s (1977) and Ball’s (1992) hypothesis say that higher inflation invokes more inflation uncertainty. In contrast, Cukierman and Metltzer’s (1986) hypothesis is that higher inflation uncertainty leads to more inflation.

Friedman (1977) says that high inflation will create political pressure to reduce it, but policy makers may fear recessionary effects and be reluctant to lower inflation, resulting in future inflation uncertainty. He argued that increased variability of inflation distorts relative prices and adds an additional risk to long term contracting. However, the issue of liaison between inflation and inflation uncertainty is still debatable. Cukierman and Meltzer (1986) showed that increased uncertainty about money supply and inflation raises the optimal inflation rate set by policymakers. Holland (1993) thinks that inflation uncertainty arises due to the unknown size of the change in price level because of a certain change in money supply. Nevertheless, studies are scarce about the relationship between inflation and inflation uncertainty in developing countries including Sri Lanka. Therefore, this study attempts to examine the whether there exists any significant relationship between inflation & inflation uncertainty in Sri Lanka. The findings of the study can have a number of policy implications for trade, monetary policy.