The Effect of Different Inflationary Regimes on the Dynamics of Inflation and Inflation Uncertainty in Iran

Inflation dynamics is a subject of numerous theoretical and empirical researches in economic literature. One important economic cost of inflation is the uncertainty that it creates about future inflation rates. This in turn causes an uncertain environment for economic activities. The households and firms’ decision under inflation uncertainty affects the allocation of resources and the level of consumption¡ investment and economic growth. Therefore¡ the issue of inflation and inflation uncertainty nexus is a hot topic in macroeconomic and monetary economics.
After the seventies many empirical researchers have studied inflation dynamics in different countries. In the last fifteen years many economists have investigated the relation between inflation and its uncertainty in both rich and poor countries. Some researchers argued that there is a positive relationship between inflation and its uncertainty¡ while there are others who find negative relationship between these two variables. More recently¡ Evans and Wachtel (1993) and Chang and He (2010) have shown that the inflation and inflation uncertainty nexus can be influenced by different inflationary regimes. They have shown that effect of inflationary shocks on its uncertainty might not be symmetric. In other words¡ the impact of positive price shocks on inflation uncertainty is different from their negative price shocks. This asymmetric effect has been the subject of recent studies.
The focus of our paper is on inflation dynamics and its relationship with inflation uncertainty in Iran. High inflation rate in recent years has adversely affected the wellbeing of many middle class and poor families in Iran and hence is an important challenge for policymakers in this country. It has become clear that the uncertainty resulted from high inflation have inflicted a heavy cost on the Iranian economy. There are many researchers that have investigated the dynamics of inflation in Iran. Among these studies¡ some have examined the relationship between inflation and inflation uncertainty in Iran. However¡ these researchers have ignored the impacts of regime switching on this relationship. The main goal of this paper is to fill this gap in the economic literature of Iran. More specifically¡ it examines how different inflation regimes can affect inflation and inflation uncertainty nexus in this country.
For this purpose¡ a Markov switching - asymmetric generalized autoregressive conditional heteroskedasticity in mean model is estimated for Iran over the period 1990:03 -2013:07. This makes it possible to change conditional variance of the error term over time and hence allows us to study the behavior of each state variable in various regimes. More specifically¡ the relationship between inflation and inflation uncertainty are examined in two different inflationary regimes¡ namely inflation pressure and inflation volatility regimes. We first study the effect of inflation uncertainty on the level of inflation in the states of increasing and decreasing inflation pressures. Second¡ we investigate the impact of inflation on inflation uncertainty when the economy is either in the state of high inflation volatility or in the state of low inflation volatility.
The estimation results show that in the state of increasing inflation pressure¡ the effect of inflation uncertainty on inflation is positive. This confirms the finding of Cukierman and Meltzer (1986). However¡ in the state of decreasing inflation pressure¡ inflation uncertainty has a negative impact on inflation. This result verifies the outcome of Holland (1995). Furthermore¡ when the economy is in the state of high inflation volatility¡ inflation has a positive effect on inflation uncertainty. This finding is consistent with the hypothesis of Ungar and Zilberfarb (1993). However¡ when the economy is in the regime of low inflation volatility¡ inflation does not affect inflation uncertainty. Moreover¡ we find that the effect of negative price shocks on inflation uncertainty is higher than that of the effect of positive price shocks.
The estimation results of transition matrix show that when the economy is in the state of increasing inflation pressure¡ it will remain in that state with probability of 95 percent and when it is in the state of decreasing inflation pressure¡ it will continue in that state with probability of 89 percent. In addition¡ when the economy is in the state of high inflation volatility¡ it will stay in this regime with probability of 98 percent and when it is in the regime of low inflation volatility¡ it will continue in the same regime with probability of 96 percent. One might infer from these findings that the inflationary regimes in Iran in highly persistence. In other words¡ when the economy enters an inflationary regime¡ the probability of chaining the state or switching the regime is low. These findings might have important policy implications for Iranian economy. Given the presence of high inflation pressure in Iran¡ one might suggest that monetary authorities should conduct price stability policy. This will allow them to curb both inflation and inflation uncertainty. Our results indicate that it is important for monetary authorities and policymakers to be aware of the type of inflationary regimes that the country is in¡ when conducting their monetary policy.