Unobserved-Component Time Series Models with Markov-Switching Heteroscedasticity: Changes in Regime and the Link between Inflation Rates and Inflation Uncertainty

In this article, I first extend the standard unobserved-component time series model to include Hamilton's Markov-switching heteroscedasticity. This will provide an alternative to the unobserved-component model with autoregressive conditional heteroscedasticity, as developed by Harvey, Ruiz, and Sentana and by Evans and Wachtel. I then apply a generalized version of the model to investigate the link between inflation and its uncertainty (U.S. data, gross national product deflator, 1958:1-1990:4). I assume that inflation consists of a stochastic trend (random-walk) component and a stationary autoregressive component, following Ball and Cecchetti, and a four-state model of U.S. inflation rate is specified. By incorporating regime shifts in both mean and variance structures, I analyze the interaction of mean and variance over long and short horizons. The empirical results show that inflation is costly because higher inflation is associated with higher long-run uncertainty.

[1]  Chang‐Jin Kim,et al.  Dynamic linear models with Markov-switching , 1994 .

[2]  James D. Hamilton.  State-space models , 1994 .

[3]  A. Harvey,et al.  Unobserved component time series models with Arch disturbances , 1992 .

[4]  Thomas B. Fomby,et al.  Shifting trends, segmented trends, and infrequent permanent shocks , 1991 .

[5]  Martin D.D. Evans,et al.  Discovering the Link between Inflation Rates and Inflation Uncertainty , 1991 .

[6]  Alex Kane,et al.  Measuring Risk Aversion from Excess Returns on a Stock Index , 1991 .

[7]  Christopher G. Lamoureux,et al.  Persistence in Variance, Structural Change, and the GARCH Model , 1990 .

[8]  Andrew C. Harvey,et al.  Forecasting, structural time series models and the Kalman filter: Selected answers to exercises , 1990 .

[9]  P. Wachtel,et al.  A Modern Look at Asset Pricing and Short-Term Interest Rates , 1990 .

[10]  Stephen G. Cecchetti,et al.  Inflation and Uncertainty at Short and Long Horizons , 1990 .

[11]  James D. Hamilton.  A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle , 1989 .

[12]  W. D. Lastrapes,et al.  Exchange Rate Volatility and U.S. Monetary Policy: An ARCH Application , 1989 .

[13]  Robert J. Barro,et al.  Interest-rate targeting , 1989 .

[14]  Thomas F. Cosimano,et al.  Estimates of the Variance of U. S. Inflation Based upon the ARCH Model: Comment , 1988 .

[15]  James D. Hamilton.  Rational-expectations econometric analysis of changes in regime: An investigation of the term structure of interest rates , 1988 .

[16]  A. Harvey,et al.  Advances in Econometrics: Applications of the Kalman filter in econometrics , 1987 .

[17]  Robert F. Engle,et al.  Advances in Econometrics: The Kalman filter: applications to forecasting and rational-expectations models , 1987 .

[18]  Robert B. Barsky,et al.  The Fisher Hypothesis and the Forecastability and Persistence of Inflation , 1986 .

[19]  James D. Hamilton,et al.  Estimation of Unobserved Expected Monthly Inflation Using Kalman Filtering , 1986 .

[20]  Madelyn Antoncic.  High and Volatile Real Interest Rates: Where Does the Fed Fit In? , 1986 .

[21]  R. Engle,et al.  Alternative Algorithms for the Estimation of Dynamic Factor , 1983 .

[22]  Robert F. Engle,et al.  Estimates of the Variance of U. S. Inflation Based upon the ARCH Model , 1983 .

[23]  Kent D. Wall,et al.  Kalman filtering estimation of unobserved rational expectations with an application to the German hyperinflation , 1982 .

[24]  R. Engle,et al.  A One-Factor Multivariate Time Series Model of Metropolitan Wage Rates , 1981 .

[25]  P. Wachtel,et al.  Time variation in the relationship between inflation and interest rates , 1978 .

[26]  R. Barro,et al.  Recent developments in monetary theory: Erratum , 1978 .

[27]  M. Friedman.  Nobel Lecture: Inflation and Unemployment , 1977, Journal of Political Economy.

[28]  P. Wachtel.  Survey Measures of Expected Inflation and Their Potential Usefulness , 1977 .

[29]  A. Okun.  The Mirage of Steady Inflation , 1971 .