Evidence of a nonlinear relationship between inflation and inflation uncertainty: The case of the four little dragons

Abstract

Using a nonlinear flexible regression model for four economies in east Asia, we re-examine two hypotheses in light of the causal relationship between inflation and inflation uncertainty. The first, proposed by Friedman [Friedman, M. (1977). Nobel lecture: Inflation and unemployment. Journal of Political Economy, 85, 451–472], postulates that increased inflation raises inflation uncertainty. Conversely, the second, put forth by Cukierman and Meltzer [Cukierman, A., & Meltzer, A. (1986). a theory of ambiguity, credibility, and inflation under discretion and asymmetric information. Econometrica, 54, 1099–1128], propounds that a high level of inflation uncertainty leads to a higher rate of inflation. Here, except for Hong Kong, overwhelming statistical evidence is found in favor of Friedman's hypothesis. The nonlinearity displays a U-shaped pattern, strongly implying that, indeed, a high rate of inflation or deflation results in high inflation uncertainty. At the same time, however, convincing evidence is found for Cukierman–Meltzer's hypothesis in favor of all four economies. Although Taiwan has an inverted U-shape, Hong Kong, Singapore and South Korea show a positive relation, thus agreeing with Cukierman–Meltzer's hypothesis.