The Link Between Inflation And Inflation Uncertainty At Short And Long Horizons: Evidence From China

The link between inflation and its uncertainty has been the focus for economists to study.However, there is no consensus about the empirical results. Ball and Cecchetti(1990) firstlydecomposed inflation uncertainty into long-term and short-term uncertainty, and analyzed therelationship between inflation and these two kinds of uncertainty. The results showed that therelationship was different according to different time horizons, which might help to breakthrough the bottleneck of empirical research. These years China is under the inflationbackground, economists pay more attention to analyze the link between inflation and itsuncertainty, but still get different results. Few existing research distinguish inflation uncertaintyinto long-term and short-term uncertainty. For analyzing the link between inflation and itsuncertainty at different time horizons to improve the rigor of analysis, we analyze the linkbetween inflation and its uncertainty at short and long time horizons in China.On empirical method, State-Space Model can not only describe the relationship betweeninput and output of the system, but also reveal the internal characteristics of the system. Manymodels can be expressed in State-Space Form for its flexible characteristics. Further more,Kalman filter can identify and estimate parameters of State-Space Model well. MarkovSwitching Model is used to describe the process of Markov containing unknown parameters, andsolve the problems of structural mutations. Kalman(1993) extended the state-space model toinclude Hamilton’s Markov-switching heteroscedasticity, which would solve structural mutationsand show flexible characteristics simultaneously.According to the achievements of economists, we apply State-Space Model withMarkov-Switching Heteroskedasticity by incorporating regime shifts in both mean and variancestructures to analyze the link between inflation and its uncertainty at short and long horizons inChina based on monthly CPI data from January1990to September2011. The empirical resultsshow that inflation is costly and causes welfare loss because higher inflation is associated withhigher long-term uncertainty.