On Measuring the Response of Real GDP Growth to Changes in Inflation Volatility

Abstract

For years a widely held belief by monetary policy practitioners has been that the volatility of inflation adversely affects the growth rate of an economy. The outcome of such a belief has been the willingness of policy makers to trade short-run output losses for progress toward price stability. Due to a void of persuasive empirical support for this belief however, policy implementation to date has had to rest primarily on faith. In this study, we provide evidence that strongly supports the hypothesized negative relationship between output growth and inflation volatility. We estimate a biva riate EGARCH-M model of real GDP growth and inflation for the United States. Our results show that (I) inflation volatility, as measured by the conditional variance of inflation, robustly and significantly negatively affects the growth rate of real GDP; and (2) inflation volatility is significantly and positively related to its own conditional mean.

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