The Inflation-Output Variability Trade-off: OECD Evidence

I. INTRODUCTION Earlier policy debates emphasized inflation-output trade-offs in levels, but the focus today is on the choice between the variability of inflation and the variability of output. Following the seminal work of Taylor (1979, 1993, 1994), it is now standard to express a central bank's objective as an expected loss function consisting of both inflation variability and output variability with different relative weights. Accordingly, if policy makers aim at lowering inflation to a predetermined target over time, then inflation will be less variable and output will inevitably exhibit larger fluctuations. Methodologically, the bulk of existing studies concerning the output-inflation volatility trade-off rely on simulations with calibrated models. Despite the popularity of this new policy trade-off as an expositional tool in explaining the choices confronting policy makers, its empirical value remains questionable for two reasons. First, as pointed out by Walsh (1998), because there is no consensus regarding which model best represents the economy, those studies inevitably lead to disagreements about the true trade-off faced by policy makers. Second, the volatility trade-off frontier is traced out in light of a series of "optimal" policy rules, each of which is simulated in a stable and optimal condition over a long time horizon. Cecchetti et al. (2001), however, find varying degrees of policy inefficiency in practice among central banks. For these reasons, the empirical significance of these simulation-based studies is limited. Another distinguishing feature of previous studies is their focus on the long run. One reason for the scarcity of empirical studies on the short-run volatility dynamics of inflation and output is that volatility behavior is not directly observable. A few exceptions include Lee (1999, 2002), who uses a bivariate generalized autoregressive conditional heteroscedasticity (GARCH) model to estimate the conditional variances of inflation and output. Based on data for the United States, his model shows support for an inflation-output volatility trade-off in the short run. The first objective of the present study is to extend this line of work to other countries. Given data availability, a sample of 22 Organisation for Economic Co-operation and Development (OECD) members has been selected. The GARCH approach has two major advantages over the conventional measure of volatility, such as moving standard deviations and squared residual terms in vector autoregressions (VARs). The first advantage is that conditional volatility, as compared to unconditional volatility, better represents perceived uncertainty (e.g., Grier and Perry, 2000), which is of particular interest to policy makers. The second advantage is that the GARCH model offers insights into the hypothesized volatility relationship in both the short run and the long run. Whereas time-varying conditional variances reveal volatility dynamics in the short run, the model also generates a longrun measure of the output-inflation covariance that will be helpful in evaluating monetary policy trade-offs, as will be illustrated in a comparison study in section IV. As Fuhrer (1997), and Cecchetti and Ehrmann (1999) point out, the output-inflation volatility trade-off relationship can be affected by many factors, including the structure of the economy and the central bank's policy toward inflation stability. Since the early 1980s, central banks around the world, including the Federal Reserve, have given particular attention to price stability. Many of them have now adopted procedures that explicitly target low or zero inflation. Against this background, the second objective of this article is to provide measures of central banks' commitment to price vis-a-vis output stability that are comparable to some recent studies. The remainder of the article is organized as follows. The next section describes the GARCH estimation model and sample data. …