Monetary Policy and Inflation Uncertainty in the United States and Germany

Abstract

Friedman's [16] proposition that increased inflation uncertainty may adversely affect real economic variables has received much attention over the last decade.' The theoretical arguments for such real effects are compelling; however, the empirical evidence on their presence and magnitude in different countries is mixed. Most results for the postwar U.S. economy strongly support the proposition [28; 25; 26; 19; 24; 7] whereas it is generally rejected for the German economy [23; 17; 8].2 While a direct comparison of the U.S. and German results is difficult due to a lack of uniform sample periods, data definitions, estimation techniques, and/or measures of inflation uncertainty, the evidence to date nevertheless suggests that the role of inflation uncertainty differs sharply between the two countries. The question then arises what factor(s) can explain the difference. One popular explanation is that the monetary authorities in the United States and Germany respond quite differently to accelerating inflation,3 so that the behavior of uncertainty differs across countries.4 The U.S. Federal Reserve is often criticized for switching frequently between the primary policy goals of price stability and full employment, possibly due to political pressures [21; 30]. Since inflation is primarily a monetary phenomenon in the long run, it is likely that such stop-and-go policies increase the uncertainty about future (steady-state) inflation, which in turn can adversely affect real output growth by reducing overall economic efficiency. The German Bundesbank, on the other hand, is reputed for its staunch and credible commitment to price stability, which often takes precedence over other policy goals. A more consistent and predictable