Uncertainty Effects of Inflation on Output: An MRS-IV Approach

Mustafa Caglayan, Ozge Kandemir, Kostas Mouratidis

Abstract

In this paper, we propose an analytical framework to explore the level and volatility eff ects of inflation on the output gap. Using quarterly US data over 1977:q2-2009:q4, we then examine the empirical implications of the model by implementing an instrumental variables Markov regime switching approach. We show that inflation uncertainty has a negative and regime dependent impact on the output gap but the level of inflation does not have any such effect. Our empirical investigation also provides evidence that the US economy is moving towards a period of turmoil before the recent financial crisis was imminent. The results are
robust to the use of alternative measures of inflation uncertainty.