Asymmetric and Time‐Varying Causality between Inflation and Inflation Uncertainty in G‐7 Countries

We use G ranger causality tests within a conditional G aussian M arkov switching vector autoregressive ( MS ‐ VAR ) model using monthly data for G ‐7 countries covering the period 1959:12–2008:10 to examine the relationship between inflation and inflation‐uncertainty. The MS ‐ VAR model allows us to model parameter time‐variation so as to reflect changes in Granger causality, assuming that these changes are stochastic and governed by an unobservable M arkov chain. Inflation uncertainty is measured as the conditional variance generated by a Fractionally Integrated Smooth Transition Autoregressive Moving Average‐Asymmetric Power ARCH ( FISTARMA ‐ APARCH ) model. The distinguishing feature of our approach from the previous studies is the determination of the sign of the G ranger causality relationship between inflation and its uncertainty over time. First, using a rolling VAR model, we show that the relationship between inflation and inflation uncertainty is time varying with frequent breaks. Second, using the MS ‐ VAR model, we obtain strong evidence in favour of the H olland's ‘stabilizing Fed hypothesis’ for C anada, F rance, G ermany, J apan, U nited K ingdom, and the U nited S tates. We also find evidence in favour of the F riedman hypothesis for C anada and the U nited S tates.