Inflation and Inflation Volatility Revisited

Abstract

AbstractThe link between inflation and its variability has been a topic of considerable interest and dispute, with theoretical disagreements and inconclusive empirical results. Empirical problems often arise from endogeneity and reverse causality. This paper reassesses the link through a system of simultaneous equations that addresses the reverse causality issue. Employing the identification through heteroskedasticity approach as an identification strategy and using a panel of 105 countries over the period 1960–2007, we find a two‐way interaction between inflation and its variability. In particular, higher inflation increases inflation volatility, which is in line with the Friedman‐Ball Hypothesis. Consistent with the Cukierman‐Meltzer arguments, moreover, greater inflation volatility fuels inflation. The evidence is robust to alternative model specifications, time periods, and country characteristics.