The purpose of this paper is to examine the relationship between inflation and inflation uncertainty in the Serbian economy, being particularly vulnerable to shocks in inflation rate, during transition period 2001 – 2007. | Yugoslav Journal of Operations Research Vol 19 (2009), Number 1, 171-183 DOI: RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY: THE CASE OF SERBIA Zorica MLADENOVIĆ Faculty of Economics, University of Belgrade, Belgrade zorima@ Received: December 2007 / Accepted: May 2009 Abstract: The purpose of this paper is to examine the relationship between inflation and inflation uncertainty in the Serbian economy, being particularly vulnerable to shocks in inflation rate, during transition period 2001 – 2007. Based on monthly data several GARCH specifications are estimated to provide the measure for inflation uncertainty. Derived variables are then included into VAR model to test for Granger-causality between inflation and its uncertainty. Models that consider only permanent and transitory components of prices are also estimated to investigate the inflation-uncertainty relationship in the long and in the short run. The main conclusion of the paper is that high inflation invokes high uncertainty, while high uncertainty negatively affects the level of inflation at long horizon. Keywords: GARCH model, inflation rate, the Cukierman-Meltzer hypothesis, the Friedman-Ball hypothesis, VAR model. 1. INTRODUCTION The cost of inflation has been a subject of substantial interest in macroeconomy. Given that inflation uncertainty represents one of the major sources of this cost, the relationship between inflation and its uncertainty has attracted considerable attention of both applied and theoretical macroeconomists. The issue was first brought up by Friedman [17] who, in his well-known Nobel Prize speech, argued that increased inflation has a potential to create nominal uncertainty that subsequently lowers welfare and possible output growth. Friedman’s idea was later formalized by Ball [3]. The relationship between inflation and inflation uncertainty was also considered in reverse direction, such that high inflation uncertainty may induce higher .
