The relationship between the rate of inflation and its unpredictability in high inflation Latin American countries

Pourgerami and Maskus (PM) (1987) find three “difficulties” in our analysis of the relationship between the rate of inflation (P) and its unpredictability (Pf) in Latin American countries.’ The first of these is a point very well taken, namely that the positive relationship we hypothesized might well be offset by a negative one arising because higher rates of inflation could be expected to induce the relevant economic agents to invest more in generating the relevant information. in utilizing it efficiently and in developing the instruments capable of hedging against inflation. However, since any such adjustments would be institutional in nature and take time to be carried out. it is obvious that this consideratipn would not be relevant for short-run analysis involving year-to-year or especially quarter-to-quarter changes in inflation rates as in our analysis. The other “difficulties.” namely that quarterly observations are more relevant than annual ones in testing such relationships and that rational expectations (RE) models of the type employed by PM are preferable to adaptive expectations models of the type we used, are criticisms more relevant to the short-run relation between inflation and its predictability, but, as we shall presently demonstrate. are not persuasive. Nevertheless. since the results presented by PM (as they have noted) show the relationship between PI and P to be considerably weaker than was indicated in earlier results (including our own). the substantial difference in results deserves explanation. Since their time coverage. frequent!. of adjustment of expectations. model of esprct;ltions and to some extent countr! coverage were all different than ours, it is not possible to learn from their results the reason for the difference. By employing the same time and country coverage as in PM, and also an estimation procedure (Hildreth-Lu) which corrects for autocorrelation, and continuing to use a modified version of our adaptive expectations model (MAE): but varying the duration of the periods, the results presented in Table 1 shed light on the source of the difference. As can be seen, the use of quarterly instead of annual data does not have a large effect on the results, thereby suggesting that PM’s use of quarterly data is not the source of their weaker results. Indeed, note that in six of the seven high inflation countries the slope coefficient is larger and more significant when quarterly data are employed than when annual data are employed. The largest differences are between the results obtained from our own MAE model estimated with quarterly data and those obtained by PM with their RE model with the same data. In all seven cases the PM estimate of @, is significantly lower than our own corresponding estimate. Which estimate is more reliable? Even if one were to agree in principle with PM that RE models are superior to AE models of price expectations, the particular RE model employed by PM can hardly be considered acceptable, let alone superior to our MAE model. With their 20 right hand side variables, i.e.. four lags of each of five different explanatory variables. relative to our four right hand side variables, it is not surprising that PM havq been able to increase the explained variation of P. correspondingly reduc-