World Development, Vol. 15, No. 2, pp. 287-290,1987. 0305-750X/87 $3.00 + 0.

00
Printed in Great Britain. 0 1987 Pergamon Journals Ltd.

The Effects of Inflation ofi the Predictability

of Price Changes in Latin America:
Some Estimates and Policy Implications

ABBAS POURGERAMI and KEITH E. MASKUS*

University of Colorado, Boulder

Summary. - This paper argues that the relationship between price variability and inflation in
high-inflation countries should be estimated on a frequent basis and that rational expectations are
the appropriate formulation for predicting inflation. Analysis of seven Latin American countries,
taking these factors into account, suggests that higher inflation contributes to the difficulty of
predicting price changes. The impact is more moderate than that found in previous studies,
however, indicating that less concern may be warranted about the possible stagflationary effects
of expansionary policies

In a recent paper Glezakos and Nugent (1984), expectations, and we attempt to correct them.
hereafter designated GN, estimated a time-series The first is the underlying hypothesis that infla-
relationship between inflation and a measure of tion rates and inflation unpredictability are posi-
price instability in Latin America. Defining price tively related. The essential reason for this
instability as the absolute difference between positive relationship is that higher inflation may
expected and observed inflation rates, where induce erratic policy responses to counter it, with
expectations were formed adaptively, they dis- consequent unanticipated inflation movements
covered significantly positive coefficients on the (Friedman, 1977). Such policy reactions result in
rate of inflation in explaining instability. These higher inflation forecast errors when inflationary
coefficients were consistently below unity, in pressures mount. A competing hypothesis may
contrast to the previous findings of Blejer (1979). be advanced, however. As inflation rises, the
This was a useful finding because it demonstrated costs of being misinformed rise as well. The
that the effect of higher inflation on price varia- erosion of real wealth and real income caused by
bility may be less drastic, though still worrisome, price increases, when contracts are poorly in-
than previously feared. dexed, is greater under high inflation. It may be
An important advantage of the GN analysis is expected, therefore, that agents in high inflation
its focus on the unpredictability of inflation. countries would devote more resources to
rather than its variability. Highly variable infla- generating accurate predictions. On this score
tion rates may not be of much concern if they are. one would expect smaller inflation prediction
at the same time. predictable. In such cases, errors as inflation rises, as there are greater
economic agents can take steps to protect them- incentives to being well informed in inflation-
selves from the generally anticipated inflation or prone countries. Overall, the relationship be-
disinflation to come. Accordingly. GN examined tween inflation and its predictability is ambigu-
the link between inflation and unexpected ous.
changes in the price level. Note, however. that The second difficulty is the assumption, im-
the existence of such unexpected movements plicit in GN, that adjustments to inflation happen
does not necessarily imply the existence of over a one-year time horizon. In fact, agents may
considerable price instability. except indirectly. be expected to adjust to changes in prices far
Thus. despite their terminology. GN have not more frequently than that, particulary in high-
provided any direct evidence on the relationship inflation environments. Individuals are capable
between inflation and price instability.
In this paper we note three difficulties with the *We are indebted to an anonymous referee for helpful
GN analysis. all related to the formation of comments.

287
288 WORLD DEVELOPMENT

of reacting to inflation quite rapidly through cedure to control for serial correlation if neces-
transactions in financial markets, though some- sary. As a final step. GN’s assertion that pooling
what less quickly in generating wage adjust- time-series and cross-section data is unwarranted
ments. It is likely, therefore, that inflation in the context of Latin American inflation and
expectations are revised rather frequently in unanticipated price changes is tested directly by
order to avoid unnecessary unanticipated adverse means of a standard generalized least squares
movements in real wealth and income._ This procedure with cross-sectional correlation and
suggests that annual measures of inflation un- time-wise autocorrelation.
predictability overstate true unpredictability. The results are presented in Table 1. .along
Accordingly, we focus in this paper on the with a computation of the inflation rates (P) and
relationship between quarterly inflation and variability measures (PI) in the GN and present
quarterly forecasting errors. quarterly data being study. Average inflation rates and instability
the most frequently available on a consistent measures in the GN paper are divided by four to
basis. be roughly comparable with our quarterly mea-
The third difficulty is that GN limited the sures. The final two columns list borne elasticity
process of expectations formation to a simple computations, to which we will return later.
adaptive process. This means only the past Notice first that extending the period of study
history of price variations is considered. while and using quarterly data do not substantially
ignoring the effects of other observable economic affect the average inflation rates. In three of the
variables on the formation of inflationary ex- countries. our inflation rates were higher than
pectations. An attractive alternative is the ration- one-fourth the average annual inflation rates in
al expectations model, in which inflationary GN. In four countries they were lower. with only
expectations are based on an information set Chile and Uruguay experiencing marked declines
containing all relevant variables at time t - 1: in the later period. Despite this apparent infla-
tion comparability. however, inflation rates were
P,r = E, [P, 1 Or_,] clearly more predictable under quarterly rational
expectations than under the hypothesis of annual
where P: is the expected inflation rate and O,_, adaptive expectations. All seven countries dis-
is the information set (Kantor, 1979). In this played less inflation uncertainty under our
paper we define the rationally expected rate of scheme than under the GN computation. In-
inflation to be the predicted value of inflation in a terestingly, the largest reduction was in Chile.
distributed lag model (maximum lag length of which also registered the largest relative decline
four quarters) whose independent variables are in average inflation. This provides weak support
the actual rate of inflation, real wage .rate, real for the hypothesis that high-inflation countries
money supply, real government expenditures, also experience greater inflation unpredictability.
and import price index.’ This relationship is clearly moderate. however,
To compute the effects of inflation on the as confirmed by the regression results. Along
predictability of price changes, we regressed the with the reduction in uncertainty we find a
absolute values of the prediction errors from the decrease in the correlation between inflation
rational expectations model on observed infla- forecast errors and inflation rates. The slope
tion in each quarter.’ The model was estimated coefficients in Table 1 accentuate GN’s finding of
for seven countries - Argentina, Brazil, Chile, coefficients less than unity: on a quarterly basis
Colombia, Mexico, Peru, and Uruguay - that they are below 0.10. Further, several of these
were among the nine highest inflation countries coefficients were only marginally significant.
in the GN study. Because the GN paper limited while Brazil and Uruguay register essentially no
the period of study to the years essentially before relationship.’
the energy crisis (1950-75). we updated the Interest arises in computing the effect of a
analysis considerably by considering quarterly marginal increase in inflation on inflation un-
observations from 1968:4 to lY85:2.” The import- certainty. Because of the discrepancy between
ance of the later period is clear from the quarterly and annual data. the coefficients here
well-known contribution of energy prices to wide and in GN are not directly comparable. To place
and rapid price fluctuations in the non-oil them on a comparable basis, we converted the
developing countries in the late 1970s (Herberg, coefficients into annual elasticities at the sample
1YXO;Cebula and Frewer. 1980). We also desired means, as reported in the final two columns. For
to incorporate the period of very recent example. the GN elasticities. which were com-
disinflationary pressures caused by commodity puted directly from their Table 1. were defined as
price reductions. The regressions were per- the estimated slope coefficients times the ratio of
formed with the Cochrane-Orcutt iterative pro- the average inflation rate to the average forecast
 PREDICTABILITY OF INFLATION IN LATIN AMERICA 2XY

Table I. Price insruhilir)~ and inflation in seven Larin American counrries under rdorwl
expecrarions (1968:4-19X5:2)

Argentina o.h3Y* 0.05x* 0.13 1.97 0.14 9.74 9.12 1.20 6.23 0.475 1.056
(2.21) (2.48)
Brazil 0.626* 0.01 1 0.04 1.16 0.14 5.04 8.31 0.66 1.83 0.082 0.886
(2.10) (0.23)
Chile 0.390 0.015 0.38 1.88 -0.19 6.37 21.75 1.10 X.92 0.084 0.444
(2.X7)? (7.54)1
Colombia 0.419 0.069 0.03 1 .70 0.15 2.04 3.03 0.56 1.55 0.244 0.734
(3.68); (1.49)$
Mexico 0.449 0.030 0.03 1.55 0.16 2.56 1.5’) 0.52 0.x0 0.144 O.XY4
(5.76); (1.30)$
Peru 0.137 0.023 0.03 1.62 0. IS 4. 10 2.43 (1.77 0.96 0.11x 1.111
(s.M)t (1.45)$
Uruguay 0.721 0.030 0.07 1.66 0.22 4.57 11.08 0.83 4.72 0.160 0.270
(2.99)1 (0.68)

Pooled 0.3YS 0.069 0.17 - - 4.92 - 0.77 - 0.428 -

(7.83pt (7.91)1

*Significant at 5% level.
tSignificant at 1% level.
*Significant at 20% level

error in each country. This provides an approxi- annual increase consists of a one quarter rise and
mation. in the nelghborhood of the sample three quarters of static prices. Since this was
means. of how sensitive price unpredictability never the case in our data. such a comparison
was to changes in the rate of inflation. In would have been inappropriate. To compensate
Argentina. for instance. the results suggest that a for this, we assumed that prices rise smoothly
1% rise in annual inflation (e.g.. from 10 to throu_ghout the year by 1% in total. This required
lO.l”L) was associated with a 1.06% rise in adjustmg the quarterly elasticities downward
inflation uncertainty over their sample periods. slightly to reflect simple compounding.
Interestingly. the two highest-inflation countries. It is clear from these computations that when
Chile and Uruguay. had the least sensitive quarterly revisions of price expectations are
relationship. with the other countries registering allowed, the relationship between inflation and
essentially unitary elasticities. Indeed. the inflation uncertainty becomes considerably
sample correlation between inflation rates and weaker. A smooth 1 “io rise in inflation over a full
elasticities was -0.571. significant at 20%. One year in Argentina led to a 0.48% increase in
might conclude from this result that countries uncertainty, less than half the previous estimate.
experiencing substantial inflation suffer greater Indeed, all of the revised elasticities were
price unpredictabilit!, as the inflation rate rises. markedly lower than the GN estimates, except
but the rate at which this unpredictability in- perhaps m Uruguav. Moreover, the link between
creases is below that of less inflationary coun- the level of inflation across countries and the
tries. This ma!’ be due to the greater incentives to sensitivity of prediction errors to changes in
predict inflation accurately in high-inflation en- inflation has been reversed. The simple correla-
vironments. as discussed earlier. tion between these variables using our results is
This relationship disappears. however, under 0.570. again weakly significant, but opposite in
the present analysis. Before discussing this. we sign to the correlation computed from the pre-
note that the elasticities from the present study vious study.
required a minor adjustment. If computed di- The primary finding to be emphasized here is
rectly using our regression coefficients and that. when allowance is made for three important
quarterI! average inflation rates and forecast factors - more frequent revisions of expecta-
errors. the!, aould represent the effect of a one tions, a more sophisticated means of incorporat-
quarter. 1110 increase in inflation. This is not ing information into the formation of expecta-
comparable to an annual 1% increase. unless that tions. and an updated data set - the link
290 WORLD DEVELOPMENT

between inflation and inflation uncertainty, while tion and price variability. This may be tested
still positive, is considerably weaker than pre- directly by a standard F-test. Allowing for a
viously thought. Accordingly, there may be less highly general model with both cross-sectional
reason to be concerned about expansionary and time-series correlation (Kmenta. 1986).
policies resulting in unacceptable stagflation. generalized least squares estimation was done
Quite simply, the reason is that inflationary with the pooled data. The F-ratio for an increase
policies are incorporated into expectations rather in residual sum of squares in the pooled model
quickly, avoiding the inefficiency costs of rapidly was 1.26, below the critical value of 1.32. As a
rising uncertainty. result, there seems to be some similarity in the
We note finally that GN criticized the common price variability-inflation relationship across
practice of pooling across countries and time to countries. The pooled model estimates are pre-
estimate an average relationship between infla- sented in the last row of Table 1.

NOTES

1. The residuals from this process were not white
noise in all cases, so these expectations should be
considered “partially rational.”
2. This is the procedure used by GN with their
adaptive expectations model; we wished to retain a
consistent formulation for comparison purposes.
Nevertheless, we consider the reladve forecast error to
be a much more powerful variability measure than the
absolure forecast error since, for example, a 3%
deviation when inflation rate is 10% is much more
important than the same deviation when inflation rate
is 100%. The latter case is certainly attributable to
random changes, while the former may clearly be the
results of problems with predictability arising from true
uncertainty in the system.
3. Of course, a substantial secondary benefit of the
quarterly analysis is an increase in the number of
observations from 16 in GN to 66 in the present study.
4. The Brazilian result is problematic because the
Cochrane-Orcutt procedure failed to remove all re-
sidual autocorrelation. Evidently. the Brazilian rela-
tionship is subject to a more complicated process than
first-order autocorrelation.

REFERENCES

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(1980), pp. 615-622. Kantor, Brian, “Rational expectations and economic
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