Inflation, uncertainty, and economic growth

Abstract

The effect of inflation on economic performance is both an important and controversial topic. Tt is important, becausc if systematic inflation has real effects, governments can influence economic performance. It is controversial, because there is little theory to justify how trend inflation can affect economic growth. In fact, while much of the empirical literature looks for a negative influence of inflation on growth, many economic theories predict neutrality or even a positive effect of inflation on growth. One major problem in the empirical literature is that most studies investigating the real effects of inflation do not control for the real effects of inflation uncertainty, or if they do, they use a measure that captures variability, but not necessarily uncertainty. In this paper, we test for the effects of inflation and inflation uncertainty on output growth in a simultaneous MGARCH-M system using data for Mexico. We show three major results. First, when the potential effect of uncertainty on growth is constrained to be zero, lagged inflation enters the output growth equation with a negative and significant coefficient. Second, when uncertainty enters the output growth equation, it is negative and significant and lagged inflation becomes insignificant. Third, we find an indirect role for average inflation in the system by demonstrating that higher average inflation raises inflation uncertainty, which in turn Iowers growth.