Inflation and Inflation Uncertainty in the Euro Area



πt+1= Xtβt+1 + et+1     et+1 ~N(0,ht)

and Xt = [1 πt, ..., πt-k, ut ...,ut-m] (1)

ht=h+aet2-1+λht-1                                                                      (2)

βt+1=βt+Vt+1       where Vt+1~N(0,Q)                                      (3)

where πt+1 denotes the rate of inflation between t and t+1; Xt is a vector of
explanatory variables known at time
t containing current and lagged values of
inflation and the unemployment rate
ut; et+1 describes the shocks to the inflation
process that cannot be forecast with information known at time
t, and is assumed to be
normally distributed with a time-varying conditional variance
ht. The conditional
variance is specified as a GARCH(
p,q) process, that is, as a linear function of past
squared forecast errors,      
e2t-i,      and past variances,      ht-j.

Further,βt+1 = [β0π,t+1,β1π,t+1,...,βkπ,t+1,β1u,t+1,...,βmu,t+1] denotes the time-varying parameter
vector, and
Vt+1 is a vector of shocks to βt+1, assumed to be normally distributed with
a homoscedastic covariance matrix
Q. The updating equations for the Kalman filter
are:

πt+1= XtEtβt+1 +εt+1                                                                    (4)

Ht = XtΩt+itXt' + ht                                                              (5)

Et+1βt+2 = Et βt+ι + [Ωt+itXtHt-1>t+1                                                    (6)

Ωt+2 t+1 = [I - Ωt+ιkXt'Ht-ιXt ]Ωt+ψ + Q                                              (7)
where
Ωt+1t is the conditional covariance matrix of βt+1 given the information set at
time
t, representing uncertainty about the structure of the inflation process.

As Equation (5) indicates, the conditional variance of inflation (short-run uncertainty),
Ht, can be decomposed into: (i) the uncertainty due to randomness in the inflation
shocks
et+1, measured by their conditional volatility ht (impulse uncertainty); (ii) the
uncertainty due to unanticipated changes in the structure of inflation
Vt+1, measured
by the conditional variance of
Xtβt+1, which is XtΩt+1tXt' = St (structural
uncertainty). The standard GARCH model can be obtained as a special case of this
model if there is no uncertainty about
βt+1, so that Ωt+1t = 0.

In this case, the conditional variance of inflation depends solely on impulse
uncertainty. Equations (6) and (7) capture the updating of the conditional distribution
of
βt+1 over time in response to new information about realised inflation. As indicated
by Equation (6), inflation innovations, defined as
εt+1 in Equation (4), are used to
update the estimates of
βt+1 . These estimates are then used to forecast future inflation.
If there are no inflation shocks and parameter shocks, so that
πt+1 =πt=... = πt-k for
all
t, we can calculate the steady-state rate of inflation, πt*+1 , as:

**
πt+1 = β0,t+1


[1-(ik=1βiπ,t+1)]


(8)




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