Inflation and Inflation Uncertainty in the Euro Area

CESifo Working Paper No. 2720

Inflation and Inflation Uncertainty
in the Euro Area

Abstract

This paper estimates a time-varying AR-GARCH model of inflation producing measures of
inflation uncertainty for the euro area, and investigates the linkages between them in a VAR
framework, also allowing for the possible impact of the policy regime change associated with
the start of EMU in 1999. The main findings are as follows. Steady-state inflation and
inflation uncertainty have declined steadily since the inception of EMU, whilst short-run
uncertainty has increased, mainly owing to exogenous shocks. A sequential dummy procedure
provides further evidence of a structural break coinciding with the introduction of the euro
and resulting in lower long-run uncertainty. It also appears that the direction of causality has
been reversed, and that in the euro period the Friedman-Ball link is empirically supported,
implying that the ECB can achieve lower inflation uncertainty by lowering the inflation rate.

JEL Code: E31, E52, C22.

Keywords: inflation, inflation uncertainty, time-varying parameters, GARCH models, ECB,
EMU.

Guglielmo Maria Caporale

Centre for Empirical Finance
Brunel University, London

West London, UB8 3PH

United Kingdom

[email protected]

July 2009

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