The Relationship between Inflation, Inflation Uncertainty and Output Growth in India

Abstract

Friedman's hypothesis regarding the relationship between inflation, inflation uncertainty and output growth states that full employment policy objective of the government tends to increase the rate of inflation which increases the uncertainty about the future course of inflation. Increase in inflation uncertainty lowers economic efficiency and reduces output growth. There are very few studies for underdeveloped countries particularly for India regarding the relationship between inflation, inflation uncertainty and output growth. Thornton's (2006) study regarding the relationship between inflation and inflation uncertainty in India is univariate in nature and it cannot establish the relationship between inflation uncertainty and output growth. This study intends use the bivariate GARCH model to find out the relation between inflation, inflation uncertainty and output growth simultaneously. In this study we use monthly data of wholesale price index (WPI) and index of industrial production (IIP) of India as the proxies of price and output respectively from 1950:1 to 2011:12. Following Fountas, Karanasos and Kim (2002) we have used the following bivariate GARCH model to estimate simultaneously the means, variances and covariances of inflation and output growth. We use Granger- causality test to know the statistical relationship between average inflation, output growth, inflation uncertainty and output growth uncertainty. We find strong evidence that increase in average inflation raises inflation uncertainty and increase in growth rate increases the growth rate uncertainty. But we do not find any statistically significant relationship between inflation uncertainty and output growth rate.