Emerging Markets Finance and Trade

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Inflation, Output Growth, and Their Uncertainties:

Empirical Evidence for a Causal Relationship from
European Emerging Economies

Carmen Pintilescu , Dănuţ-Vasile Jemna , Elena-Daniela Viorică & Mircea

Asandului

To cite this article: Carmen Pintilescu , Dănuţ-Vasile Jemna , Elena-Daniela Viorică & Mircea
Asandului (2014) Inflation, Output Growth, and Their Uncertainties: Empirical Evidence for
a Causal Relationship from European Emerging Economies, Emerging Markets Finance and
Trade, 50:sup4, 78-94

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 78  Emerging Markets Finance & Trade

Inflation, Output Growth, and Their

Uncertainties: Empirical Evidence for a
Causal Relationship from European
Emerging Economies
Carmen Pintilescu, Dă nuţ-Vasile Jemna, Elena-Daniela Viorică ,
and Mircea Asandului
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ABSTRACT: In this paper, we analyze the causality among inflation, output growth, and their
uncertainties in all European countries with emerging economies. For these countries, high
uncertainty regarding economic growth during the current economic and financial crisis
that started in 2008 caused their governments to increase their efforts to sustain growth,
and to maintain a low level of inflation. Of the twelve possible hypotheses regarding the
causal relationships among inflation, output growth, and their uncertainties, we consider
five relationships for which we find strong theoretical arguments and empirical evidence
in the literature. The empirical evidence strongly supports the Friedman–Ball hypothesis
that inflation Granger-causes inflation uncertainty. For the other four tested hypotheses,
fewer significant causal relationships are obtained.
KEY WORDS: European emerging economies, heteroskedastic model, inflation, output
growth, uncertainty.

The economic evolution in the emerging European countries is the topic of interest for
many specialists in the field,1 especially in the context of the current global economic crisis,
which has diminished the growth of these economies still facing high inflation rates.
Most of the European countries with emerging economies are members of the European
Union (EU), and reaching macroeconomic stability represents a priority goal to ensure
real convergence with the economy of developed countries. Maintaining a low inflation
rate and ensuring a sustainable economic growth can raise the output per capita to a level
approaching the EU average and can ensure real economic convergence.
Ensuring macroeconomic stability is a main objective of every economy. In recent
decades, the economies of the emerging countries have experienced a high variability in
output and inflation rates. The adoption of economic, political, and institutional reform
measures for the emerging countries’ economies has generated a very high inflation rate
and significant reductions in the rhythm of economic growth. Diminishing inflation has

Carmen Pintilescu (carmen.pintilescu@uaic.ro) is a professor of statistics and data analysis at

Alexandru Ioan Cuza University, Iaşi, Romania. Dănuţ-Vasile Jemna (danut.jemna@uaic.ro) is an as-
sociate professor of econometrics at Alexandru Ioan Cuza University, Iaşi, Romania. Elena-Daniela
Viorică (dana.viorica@gmail.com) is a lecturer of statistics at Alexandru Ioan Cuza University,
Iaşi, Romania. Mircea Asandului (asmircea@yahoo.com) is an assistant lecturer of econometrics
at Alexandru Ioan Cuza University, Iaşi, Romania. An initial version of this paper was presented
at the international conference on Globalization and Higher Education in Economics and Business
Administration (GEBA 2012), Iaşi, Romania, October 18–20, 2012. The authors thank participants
at the conference, two anonymous referees, and the editor of this journal, Ali M. Kutan, for helpful
comments and suggestions on earlier versions of this paper.

Emerging Markets Finance & Trade / July–August 2014, Vol. 50, Supplement 4, pp. 78–94.
© 2014 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 1540–496X (print) /ISSN 1558–0938 (online)
DOI: 10.2753/REE1540-496X5004S405
 July–August 2014, Volume 50, Supplement 4  79

become a priority goal of the economic policies of these countries. The economic and
social costs generated by high inflation have made price stability, via reduced and stable
inflation, the most important goal of the countries’ monetary policies.
Even if in recent years the emerging countries have known economic growth rates
that are superior to the EU growth level, the present economic crisis has caused their
slowdown or reduction. These evolutions have accentuated the uncertainty regarding the
ability of emerging countries to ensure sustainable economic growth under the conditions
of maintaining a reduced inflation level. Even in the countries that have the fastest-growing
economies (e.g., Turkey,with a growth rate reaching 9.2 percent in 2010 and 8.5 percent
in 2011),2 relatively high inflation remains a main concern.
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In this context, the study of the relationships among inflation, output growth, and their
uncertainties in emerging economies, which have known significant changes in their evolu-
tion, represents a highly interesting topic both for the policymakers from these countries
and for other countries in a similar position. The interdependencies among inflation,
output growth, and their uncertainties are mainly determined by the implementation and
the success of monetary policy.
The relationships between economic variables and their uncertainties have been exten-
sively researched since the 1970s. The literature on the subject is vast and encompasses
both the theoretical foundation for the existence and direction of those relationships and
the empirical evidence for the developed and transition economies. We have not found
in the literature any other investigations for all the emerging economies in Europe.
In this paper, we analyze five of the relationships for which we have found strong argu-
ments from economic theory and empirical evidence in the literature, for ten emerging
economies in Europe:3 Bulgaria, Estonia, Hungary, Latvia, Lithuania, Poland, Romania,
Russia, Turkey, and Ukraine. The contribution of this paper is the empirical analysis of
the relationships among economic growth, inflation, and their uncertainties for all of the
emerging economies in Europe, which have specific features characterized by relatively
high growth rates and high inflation.

Literature Review
The most-investigated issue concerns the relationship between inflation and inflation
uncertainty, beginning with the pioneering interest of Okun (1971), who finds a positive
relationship between inflation rate and inflation variability for seventeen Organization for
Economic Cooperation and Development (OECD) countries. The milestone is Friedman’s
(1977) contribution to the real effects of inflation. He states first that an increase in infla-
tion will lead to more uncertainty about inflation and second, that an increase in inflation
uncertainty leads to a decrease in output.
Ball (1992) develops and confirms the first part of Friedman’s (1977) hypothesis.
Pourgerami and Maskus (1987), and later Ungar and Zilberfarb (1993), also study the
relationship between inflation and inflation uncertainty and find evidence that infla-
tion influences uncertainty about inflation. Unlike Friedman (1977) and Ball (1992),
Pourgerami and Maskus (1987) and Ungar and Zilberfarb (1993) find that high inflation
reduces uncertainty about inflation.
Regarding the second part of Friedman’s hypothesis, Dotsey and Sarte (2000) have one
of the most significant contributions in analyzing the effects of inflation uncertainty on
output growth. They find evidence of a positive relationship between the two variables—
high inflation variability increases economic growth.
 80  Emerging Markets Finance & Trade

Table 1. The investigated hypotheses and main theoretical contributions for

each
Sign of the causal
Hypothesis relationship

H1: Inflation Granger-causes inflation uncertainty.

Ball (1992), Friedman (1977) +
Pourgerami and Maskus (1987), Ungar and Zilberfarb (1993) –
H2: Inflation uncertainty Granger-causes output growth.
Dotsey and Sarte (2000) +
Friedman (1977) –
H3: Inflation uncertainty Granger-causes inflation.
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Cukierman and Meltzer (1986) +

Holland (1995) –
H4: Output uncertainty Granger-causes inflation.
Cukierman and Gerlach (2003), Devereux (1989) +
Cukierman and Meltzer (1986) –
H5: Output uncertainty Granger-causes output growth.
Black (1987), Blackburn (1999), Mirman (1971) +
Pindyck (1991) –

Source: Fountas and Karanasos (2007).

Cukierman and Meltzer (1986) also study the relationship between inflation and infla-
tion uncertainty and find that when uncertainty about inflation increases, it causes high
rates of inflation. Holland (1995) finds the same causality but with a negative relationship
between variables.
The relationships between output uncertainty and economic variables are also under
investigation. There is enough empirical evidence to support the hypothesis that the rate
of inflation is influenced by output uncertainty, either positively (Cukierman and Gerlach
2003; Devereux 1989) or negatively (Cukierman and Meltzer 1986), and that output growth
is influenced by output uncertainty, either positively (Black 1987; Blackburn 1999; Mir-
man 1971) or negatively (Pindyck 1991). Less-strong empirical or theoretical evidence is
found to support the hypothesis that output growth causes uncertainty about inflation or
uncertainty about output growth. Therefore, the analysis of such hypotheses is dropped.
To investigate the relationships among inflation, output growth, and their uncertainties,
considering all of the causal effects between each pair of variables, we can study twelve
possible causal relationships for the four variables considered.
As previously stated and in compliance with Fountas and Karanasos’s (2007) argu-
ments, considering that there are poor theoretical arguments and weak empirical evidence
for some of the relationships, we investigate only five causal relationships between the
variables under the form of five hypotheses, as presented in Table 1.
For all the tested hypotheses, there are two types of causal relationships: a positive
and a negative. In Table 1, we present the most-significant contributions made for each
type of causal relationship.
H1 is, as previously stated, the most investigated of the five and has the strongest
theoretical and empirical background, given the debates around Friedman’s (1977)
Nobel-awarded contribution. The other four hypotheses test the causality between the
two uncertainties and macroeconomic variables. The most important economic theories
and arguments are presented for each of the five hypotheses.
 July–August 2014, Volume 50, Supplement 4  81

Hypothesis 1: Inflation Granger-causes inflation uncertainty.

Ball (1992) and Friedman (1977) investigate and find evidence of a positive relation-
ship between inflation and inflation uncertainty. They state that when the inflation rate
increases, the monetary authority does not have a predictable and reliable response,
and that, in turn, generates uncertainty about the future rate of inflation for the public
because the money supply growth cannot be predicted. Pourgerami and Maskus (1987)
and Ungar and Zilberfarb (1993) find evidence that high inflation may lead to a lower
uncertainty about inflation because, in the event of increased inflation, more resources
would be invested to accurately predict the future inflation rate, and that would lower
the uncertainty level.
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Hypothesis 2: Inflation uncertainty Granger-causes output growth.

Dotsey and Sarte (2000) build a cash-in-advance model that includes, as an influence
factor, precautionary savings, and find evidence that increased inflation uncertainty has
a positive effect on output growth. According to them, when monetary growth is more
variable, agents increase their precautionary savings; thus, the available funds for invest-
ments increase, leading to growth. Friedman (1977) argues that when inflation uncertainty
increases, it negatively affects the price mechanism by distorting its allocative efficiency.
The uncertainty affects the allocation of resources by affecting the interest rates, the real
cost of the production factors, or the prices of final goods; therefore, it has a negative
effect on output growth.
Hypothesis 3: Inflation uncertainty Granger-causes inflation.
Cukierman and Meltzer (1986) find support for a positive relationship between inflation
uncertainty and inflation, arguing that when inflation uncertainty increases, the policy
authority exhibits opportunistic behavior; that is, it generates surprise inflation for the
economic agents by increasing the growth rate of the money supply in order to obtain
output gains. Holland (1995) finds evidence of a negative relationship, suggesting that
in the case of increased inflation uncertainty, policymakers exhibit stabilizing behavior,
meaning that they reduce the money supply growth rate in order to reduce the negative
welfare effects. Grier and Perry (1998) suggest that the opportunistic or stabilizing behav-
ior of the monetary authorities is related to the level of central bank independence. The
higher the level of central bank independence, the lesser the inflation rate.
Hypothesis 4: Output uncertainty Granger-causes inflation.
Devereux (1989) investigates the positive relationship between output uncertainty and
inflation and argues that increases in output uncertainty lead to a decrease in the optimal
amount of wage indexation. This situation forces the policymakers to increase inflation
by creating inflation surprises for the agents in order to obtain output gains. Cukierman
and Meltzer (1986) find theoretical support for the negative relationship between output
uncertainty and inflation. They state that higher uncertainty about output growth reduces
inflation uncertainty and, consequently, the rate of inflation.
Hypothesis 5: Output uncertainty Granger-causes output growth.
Mirman (1971) argues that more output-growth uncertainty leads to increased precau-
tionary savings rates and to a higher output-growth rate. Black (1987) also argues that
investments, which lead to output growth, will be made in uncertainty conditions only if
expected returns are large enough to compensate for the investment risks. Pindyck (1991)
 82  Emerging Markets Finance & Trade

finds evidence of a negative relationship between output uncertainty and output growth,
suggesting that when the uncertainty about future profits from investments is high, it
raises the value of waiting, delaying the investments made at firm level and leading to
lower output growth.
We test all five hypotheses for the ten emerging European economies: Bulgaria,
Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Turkey, and Ukraine.
Several studies find empirical evidence for the countries under analysis, for some or all
of the five investigated hypotheses, as presented in Table 2. From those studies, two are
the most extensive: Hasanov and Omay (2011) and Khan et al. (2013), who investigate
all twelve causal relationships among the four variables.4 All other studies that analyze
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samples of our targeted countries focus on the relationship between inflation and infla-
tion uncertainty.
Because of its inflation problems, Turkey has been widely studied. Thus, of the
countries analyzed, Turkey is the subject of the largest body of empirical studies for the
investigation of the causal relationship between inflation and inflation uncertainty.
For all countries, mixed results are obtained for each of the five hypotheses tested,
given that different econometric models and periods are used. The most obvious sup-
port is found for the Friedman–Ball hypothesis. For all countries except Estonia, we
find evidence for H1. However, for the other hypotheses, there are no evident patterns to
support a specific type of causality.

Data and Methodology

To identify the European emerging economies, we analyze classifications made by several
institutions with expertise in the field, such as Standard and Poor’s, Dow Jones, and the
International Monetary Fund (IMF). We use the classification conducted by the IMF on
July 16, 2012, which considers twenty-four countries as being emergent, of which ten
are European economies. Therefore, the countries in this study are Bulgaria, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Russia, Turkey, and Ukraine. We have not
found in the literature any other investigations for a panel of these countries.
In our empirical analysis, for inflation measuring, we use the consumer price index
(CPI), similar to the studies by Dibooglu and Kutan (2005), Gillman and Harris (2008),
Khan et al. (2013), and Mladenović (2009). For measuring output growth, we use the
industrial production index (IPI), which is used for the assessment of this indicator in
the studies by Fountas et al. (2006) and Hasanov and Omay (2011).
The data source is International Financial Statistics, published by the IMF, which
contains monthly data for the period January 1990–May 2013 for the sample under
consideration. We measure inflation (π) by the annualized monthly difference of the
log of the CPI (Fountas et al. 2006) [πt = ln(CPIt  /CPIt–1) × 1200] and the output growth
(yt ), which is considered through the annualized monthly difference in the log of the IPI
(Fountas 2006) [yt = ln(IPIt /IPIt–1) × 1200].
There are several possibilities for the estimation of inflation uncertainty and output
growth. The simplest are proposed by studies such as Davis and Kanago (2000) and
Hafer (1986), who measure the rate of inflation based on the standard deviation, and
Johnson (2002), who determines the uncertainty on the basis of the error generated by
a simple forecast model.
Another extensive part of the literature proves that uncertainty can be estimated with
good results by means of the conditional variance estimated through an autoregressive
conditional heteroskedastic model, such as the ARCH-GARCH type. Some authors
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Table 2. Significant body of empirical evidence in the literature for the investigated hypotheses and countries
Hypotheses/sign/lags

Country Research paper H1 H2 H3 H4 H5 Period Model

Bulgaria Hasanov and Omay (2011) FB – 12 DS – 12 H–4 CM – 4, 12 B–8 2000–2007 CCC GARCH (1, 1)
Khan et al. (2013) FB – 4, 8, 12 DS – 8 — — B – 4, 8, 12 2000–2011 E-GARCH (1, 1)
Estonia Khan et al. (2013) PM – 4, 8, 12 — — D – 4, 8 P–4 2000–2011 E-GARCH (1, 1)
Hungary Hasanov and Omay (2011) FB – 4, 8, 12 F–4 CM – 4, 8, 12 — P–4 1985–2007 CCC GARCH (1, 1)
Latvia Ajevskis (2007) FB – 5, 10, — CM – 5, 10, — — 1994–2007 GARCH-M
20, 30 20, 30
Lithuania Hasanov and Omay (2011) — — — — B – 4, 8, 12 1997–2007 CCC GARCH (1, 1)
Khan et al. (2013) FB – 4, 8, 12 — H – 4, 8, 12 CM – 12 P–8 2000–2011 E-GARCH (1, 1)
Poland Hasanov and Omay (2011) FB – 4, 8, 12 F – 8, 12 H – 4, 8, 12 D – 4, 8, 12 P – 4, 8, 12 1988–2007 CCC GARCH (1, 1)
Khan et al. (2013) FB – 4,8, 12 — H – 12 — B – 4, 12 2000–2010 E-GARCH (1, 1)
Romania Hasanov and Omay (2011) FB – 4, 8, 12 DS – 12 H–4 — — 2000–2007 CCC GARCH (1, 1)
F – 4, 8
Khan et al. (2013) FB – 4, 8, 12 — — — B – 4, 8, 12 2000–2011 E-GARCH (1, 1)
Russia Erkam and Cavusoglu FB – 4, 12 — CM – 4, 8, 12 — — 1997–2007 GARCH (1, 1)
(2008) PM – 8
Baharumshah et al. FB (10) — — — — 1991–2008 ICSS-EGARCH –
(2011) M-t
Turkey Berument et al. (2011) — — CM — — 1984–2009 SVM
Nas and Perry (2000) FB – 4, 8, 12 — H – 4, 8, 12 — — 1960–1998 GARCH (1, 1)
Keskek and Orhan (2010) FB — H — — 1984–2005 GARCH-M
Ukraine Erkam and Cavusoglu FB – 4, 8 — CM – 8 — — 1997–2007 GARCH (1, 1)
(2008)
Baharumshah et al. FB – 10 — H – 10 — — 1992–2008 ICSS-EGARCH –
(2011) M-t

Notes: FB: Friedman–Ball; PM: Pourgerami–Maskus; F: Friedman: DS: Dotsey–Sarte; H: Holland; CM: Cukierman–Meltzer; D: Devereux; P: Pindyck; B: Black;
SVM: stochastic volatility in mean.
July–August 2014, Volume 50, Supplement 4  83
 84  Emerging Markets Finance & Trade

use models that are easy to control and manipulate, such as the generalized autoregres-
sive conditional heteroskedasticity (GARCH) model (Evans 1991; Neanidis and Savva
2010; Võrk 2000). Other authors use exponential GARCH (EGARCH) (Asghar et al.
2011; Baharumshah et al. 2011) or more complex models such as GARCH-in-mean
(GARCH‑M) (Ajevskis 2007; Grier et al. 2004; Khan 2010).
In a data analysis for Turkey, Berument et al. (2011) estimate uncertainty through a
stochastic volatility in mean (SVM) model.
We consider several heteroskedastic models (GARCH, EGARCH, GARCH-M) that
are in accord with the literature and recent research papers. Depending on the values of
the information criteria (Akaike, Schwarz, Hannan–Quinn), we are able to choose the
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model that is the best fit for each country in the sample.
The first step in the proposed analysis is to test the stationarity of the series that we
consider (for each of the ten countries). If the stationarity hypothesis is not confirmed
for one of the series, then the series must be stationarized through one of the known
traditional procedures, such as the creation of the series of first-order differences. To test
the stationarity, we use the augmented Dickey–Fuller (ADF), Phillips–Perron (PP), and
Kwiatkowski–Phillips–Schmidt–Shin (KPSS) tests.
According to the methodology used by Fountas and Karanasos (2007), depending
on the stationary series, we use a bivariate vector autoregressive (VAR) model, which
estimates the conditional means of the inflation rate and the output growth. The main
purpose of modeling these correlations with VAR is to identify the optimum lag length
of their correlation. The number of lags is chosen according to the Akaike information
criterion (AIC) and the Schwarz information criterion (SIC).
For inflation (πt) and output growth (yt), a bivariate VAR(p) model is of the form
p
xt = φ0 + ∑ φi ⋅ xt −i + εt , (1)
i =1

where
 φπ 0   φπ π,i φπ y ,i 
φ0 =   , φi =  
 φy 0   φyπ,i φy y ,i 
and xt is the vector formed of the series πt and yt.
The next step of the methodology is to estimate the uncertainties for the two variables
considered: inflation and output growth. When estimating the GARCH models for infla-
tion and output growth, we consider the existence of a causality relationship between
these two. The Granger causality test is applied to analyze the causal relationship. We
measure the uncertainties through the conditional variance of these variances that are
estimated based on the three GARCH models considered.
The GARCH methodology (Bollerslev 1986) offers the possibility to measure uncer-
tainty for inflation and output growth, including the lagged conditional variances as
autoregressive terms.
For GARCH (1, 1), the model has the specification
Yt = µ + β′Xt + εt, (2)
where Xt is a k × 1 vector of independent variables; β is a k × 1 vector of regression coef-
ficients; and εt is the residual, respecting the condition εt ∼ N(0, ht ); ht is the conditional
variance, which is estimated by the equation
 July–August 2014, Volume 50, Supplement 4  85

ht = α0 + α1 ⋅ ht–1 + α  2 ⋅ ε2t–1. (3)

The EGARCH (1, 1) (Nelson 1991) has the same specification, but the conditional
variance is obtained by the equation
ln ht = α0 + α1 · ln ht–1 + γ1ξt–1 + γ2 | ξt–1|, (4)
where ξt = εt /ht 1/2.
Finally, the GARCH-M (1, 1) (Engle et al. 1987) model has the same conditional
variance as GARCH (1, 1), but the conditional mean depends on its own conditional
variance. This model has the specification
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Yt = µ + β′Xt + θht + εt. (5)

Once the two uncertainties are estimated, a Granger causality test for four, eight, and
twelve lags is undertaken. The causality tests are applied for the five relationships built
among inflation, output growth, and their uncertainties, with the corresponding number
of lags. The results of the tests indicate the type of correlation between the variables, and
the significant correlations are estimated by means of a VAR model in order to determine
the sign of the causality.

Empirical Results
Data Description
Inflation is measured by the annualized monthly difference of the log CPI, and the output
growth is measured by the annualized monthly difference of the log of the IPI. The sum-
mary statistics of these two variables are given in Table 3.
The data from Table 3 indicate very high values of inflation for certain countries. The
starting date of our series coincides with the period when the Central and East European
countries changed to the market economy system, and price liberalization was one of the
first economic measures adopted in these countries. Following the measures of economic
policy adopted in the 1990s, the yearly inflation in some countries exceeded 200 percent
(e.g., in 1993 in Romania, the rate of inflation was 256.1 percent). In many countries, the
reformation and restructuring process of the economic system caused drastic real output
drops during the early stages of transition.

Empirical Evidence
In the first stage of the study, we test the stationarity of data series using the ADF and
PP tests, for which the null hypothesis is nonstationarity, and the KPSS test, for which
the null hypothesis is stationarity. The applied tests indicate that inflation and output-
growth rate are stationary.5 For Latvia and Turkey, the ADF test does not reject the
nonstationarity hypothesis for inflation; for Bulgaria and Ukraine, the ADF test does
not reject the nonstationarity hypothesis for output growth. The other stationarity tests
sustain the series stationarity hypothesis, thus we use the series for the second part of
the empirical analysis.
The empirical analysis continues with the application of VAR and Granger causality
test methods in order to identify the adequate number of lags for each variable, as well as
the lead-lag interactions between variables. The results are presented in Appendix A.
 86  Emerging Markets Finance & Trade

Table 3. Summary statistics for inflation and output growth

Inflation (CPI) Output growth (IPI)

Standard Jarque– Standard Jarque–

Country Mean deviation Bera Mean deviation Bera

Bulgaria 2.34 4.61 12.77 1.42 40.05 41.82

Estonia 1.78 2.39 27.40 2.24 15.42 20.46
Hungary 4.84 5.84 1,528.32 1.55 49.98 1.71
Latvia 1.96 3.24 14.16 1.93 18.29 205.96
Lithuania 1.25 2.64 51.78 2.30 46.40 5.68
Poland 5.79 9.15 4,148.06 1.94 34.53 1.52
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Romania 15.97 2.70 1,192.80 0.18 38.07 4.18

Russia 7.97 13.98 61,184.78 0.29 32.51 1,323.73
Turkey 14.47 13.68 1,134.73 1.70 43.54 2.17
Ukraine 3.82 5.19 2.46 1.58 31.27 6.79

By applying the VAR lag order selection criteria method, we identify the maximum
number of lags for each relation between inflation and output growth by means of the
available information criteria: likelihood ratio, AIC, SIC, Hannan–Quinn. By applying
VAR Granger causality, we identify the dependent variable that will be used to estimate
the three specified models (GARCH(1, 1), EGARCH(1, 1), GARCH-M(1, 1)).
As stated earlier, we choose the model that is the best fit using information criteria.
The equations estimated for inflation and output growth are presented in Appendix B.
Using the informational criteria, we select the GARCH-M(1, 1) model to estimate
the uncertainties of inflation and output growth. The estimated equations are presented
in Appendix C.
In the next step, we proceed to test the five economic hypotheses using the Granger
causality approach. The results of Granger causality tests among inflation, output growth,
and their uncertainties are presented in Table 4.
The results of the Granger causality tests allow the formulation of the following
conclusions. From the five tested hypotheses, the strongest empirical evidence is found
for the first part of the Friedman (1977) hypothesis (H1), which is confirmed for five
countries: Latvia, Poland, Romania, Russia, and Turkey. Pourgerami and Maskus’s
(1987) hypothesis is confirmed only for Ukraine; its history of extremely high inflation,
combined with low public confidence in the government and state institutions’ ability
to emerge from the economic and energy crisis, leads to the conclusion that even if the
inflation level drops, uncertainty about inflation will remain high.
H2 mainly supports Friedman’s (1977) theory that uncertainty about inflation is detri-
mental to output growth. This is confirmed in four of the analyzed countries, with strong
empirical evidence for Russia and Romania.
The only theory confirmed for H3 is Holland’s (1995). The strongest empirical evi-
dence to support Holland’s theory is found for Romania and Turkey, meaning that a rise
in inflation uncertainty leads to a lower inflation rate, suggesting that their monetary
authorities show a stabilizing behavior.
H4 is fully confirmed only for Romania and Hungary, but with different effects of
output uncertainty on inflation. Devereux’s theory is confirmed for Romania, where the
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Table 4. Granger causality tests among inflation, output growth, and their uncertainties
Poland Russia Romania Bulgaria Hungary Latvia Lithuania Ukraine Turkey Estonia

H0: Inflation does not Granger-cause inflation uncertainty

4 lags 2.79* (+) 766.03* (+) 129.54* (+) 2.35 0.60 17.87* (+) 0.84 41.74* (–) 35.86* (+) 0.67
8 lags 2.11* (+) 390.39* (+) 74.30* (+) 2.18* (+) 1.90 7.21* (+) 1.59 20.74* (–) 21.25* (+) 1.79
12 lags 2.21* (+) 277.42* (+) 63.89* (+) 1.87* (–) 1.50 6.74* (+) 1.82 16.90* (–) 18.01* (+) 1.70
H0: Inflation uncertainty does not Granger-cause output growth
4 lags 1.01 23.89* (–) 2.43* (–) 1.33 2.39 3.40* (–) 0.36 3.95* (–) 1.05 1.34
8 lags 2.46* (+) 13.49* (–) 2.36* (–) 1.63 1.58 1.80 1.01 2.28* (–) 0.45 0.55
12 lags 1.36 12.40* (–) 2.21* (–) 1.60 0.57 1.77 1.23 0.72 1.34 0.76
H0: Inflation uncertainty does not Granger-cause inflation
4 lags 0.37 1.55 2.32* (–) 2.36 0.40 1.25 1.14 0.56 7.23* (–) 2.82* (–)
8 lags 0.33 0.80 2.01* (–) 1.36 0.75 0.57 0.66 1.01 2.89* (–) 0.86
12 lags 0.67 0.58 3.52* (–) 1.79 1.21 2.28* (–) 1.78 0.48 2.92* (–) 0.99
H0: Output uncertainty does not Granger-cause inflation
4 lags 1.99 0.85 10.12* (+) 1.05 2.50* (–) 3.06* (–) 2.09* (–) 1.00 0.21 0.77
8 lags 1.06 0.45 5.80* (+) 0.60 5.92* (–) 1.82 1.23 1.28 0.40 0.56
12 lags 1.31 0.31 2.95* (+) 0.68 2.00* (–) 1.33 0.55 1.15 0.57 0.80
H0: Output uncertainty does not Granger-cause output growth
4 lags 1.43 2.52* (+) 0.58 0.33 5.49* (–) 9.27* (+) 2.95* (+) 4.68* (–) 0.89 0.88
8 lags 0.87 1.90* (+) 0.99 0.62 4.46* (–) 7.27* (+) 0.84 2.08* (–) 1.98 0.62
12 lags 0.96 1.94* (+) 1.18 2.14* (–) 1.35 4.35* (+) 0.67 1.32 0.97 0.75

Notes: Values are F-statistics. + (–) indicates that the sum of the lagged coefficients of the causing variable is positive (negative). * Significance at the 0.05 level.
July–August 2014, Volume 50, Supplement 4  87
 88  Emerging Markets Finance & Trade

Table 5. Empirical evidence on the five investigated hypotheses by country

H1 H2 H3 H4 H5

Bulgaria FB**/PM** — — — P**

Estonia — — H** — —
Hungary — — — CM* P**
Latvia FB* F** H** CM** B*
Lithuania — — — CM** B**
Poland FB* DS** — — —
Romania FB* F* H* D* —
Russia FB* F* — — B*
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Turkey FB* — H* — —
Ukraine PM* F** — — P**

Notes: FB: Friedman–Ball; PM: Pourgerami–Maskus; F: Friedman: DS: Dotsey–Sarte; H: Holland;

CM: Cukierman–Meltzer; D: Devereux; P: Pindyck; B: Black; — indicates no significant causal rela-
tionships were found. * Hypothesis verified for all lags. ** Hypothesis verified for some lags.

increase in output uncertainty results in a lower degree of wage indexation, which allows
policymakers to increase inflation in order to attain higher output objectives. Because of
this low indexation, Romania had, in 2013, the lowest level of minimum wage/month in
the European Union, despite its high output-growth rates in the years prior to 2013.
H5 is fully confirmed only for Russia and Latvia and supports Black’s theory that
output-growth uncertainty is not detrimental to output growth. For Russia, even though
the uncertainty about output growth increased after the financial crisis in 1998, the rate
of output growth continued to increase because Russia’s primary source of economic
growth was the production of natural resources of gas and oil and because Russia’s level
of indebtedness was relatively low.
In Table 5, we present a synthesis of the results of our analysis by country.
Comparing our findings with the empirical results from the extant literature presented
in Table 2, we underline two aspects. First, there is concurrence with the literature for
H1, that inflation Granger-causes inflation uncertainty not only for the countries in our
sample, but also for developed economies in other studies (Caporale et al. 2010; Fountas
and Karanasos 2007; Grier and Perry 1998; Hartmann and Herwartz 2012; Hartmann and
Roestel 2013). Second, for the other hypotheses tested, the empirical results vary con-
sistently across the literature, even for this sample of countries that have similar features
and economic backgrounds. We do not find strong empirical evidence that uncertainty,
which is present in the economic climate of the emerging countries, is detrimental to
economic growth.

Conclusions
The purpose of this paper is to examine the causality among inflation, output growth, and
their uncertainties in ten European countries with emerging economies. The uncertainties
are estimated by heteroskedastic models. We use monthly data for the period January
1990–May 2013 for the European emerging economies, which are determined according
to the International Financial Statistics classifications.
 July–August 2014, Volume 50, Supplement 4  89

The study of the relationships among inflation, output growth, and their uncertain-
ties for these sample countries—which have specific features such as a process of rapid
growth and industrialization, and are accompanied by high levels of inflation—offers
significant theoretical and empirical support for the decisions of the policymakers. For
these countries, the high uncertainty regarding economic growth in this period of crisis
caused their governments to increase their efforts to sustain growth, and to maintain a low
level of inflation. We consider this large sample period because it comprises important
changes in the dynamics of these economies.
We investigate five research hypotheses. The first hypothesis regards the relationship
between inflation and inflation uncertainty; the other four test the causalities between
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the two uncertainties and the macroeconomic variables.

The most significant results are obtained for the first hypothesis, confirming the
Friedman–Ball hypothesis. For the other four hypotheses, fewer significant causal rela-
tionships are obtained. For the Friedman–Ball hypothesis, we find strong concurrence
with the empirical evidence in the literature. In the 1990s, the emerging economies in
the Central and Eastern European countries experienced great inflationist phenomena
because of the price liberalization measures and economic reforms necessary to change to
a market economy. The delay and inconsistency of the reform measures of the economy,
the gradual but overly extended liberalization of prices for some of the countries, have
caused the inflation phenomenon to occur over a long period and have generated a con-
sistent uncertainty about the future rate of inflation.
For the other hypotheses, the most convincing empirical evidence is obtained for H2
and H3. For H2, the evidence supports Friedman’s (1977) theory, suggesting that inflation
uncertainty is prejudicial to economic growth. For four of the analyzed countries, H3
confirms Holland’s (1995) theory that inflation uncertainty has a positive economic effect
on inflation. For H4 and H5, the evidence obtained is mixed, so no obvious economic
conclusion can be drawn.
For the European emerging economies, policymakers should have taken measures both
to reduce inflation and to stimulate economic growth. Given the spread of changes that
needed implementation, it is not obvious which goal should have taken priority. Moreover,
the adopted measures and the efforts of economy stabilization bring forth their effects
after a long span of time. The complexity of predicting how much and how quickly prices
will respond to the adopted measures creates uncertainty about future inflation, even if
the final aim is certain, affecting the economic growth rate.
A future direction of our research regards the analysis of a nonlinear relationship
between the macroeconomic variables and their uncertainties, as a new approach presented
in the recent literature (Neanidis and Savva 2013), as well as the causality analysis for
subsamples of data according to each country’s specific monetary policy strategies.

Notes
1. Analysis of economic situations in emerging European countries, with approaches from
different perspectives, is an increasingly important research topic in the literature. See, for example,
de Melo et al. (2001) and Peltonen et al. (2011).
2. Turkey is a frequently studied case in the literature regarding inflation. See Berument et al.
(2011) and Genc and Balcilar (2012).
3. The literature contains several classifications of emerging countries. In this study, we use
the classification proposed by the International Monetary Fund.
 90  Emerging Markets Finance & Trade

4. Hasanov and Omay (2011) use a ten-country sample; Khan et al. (2013) use a six-country
sample.
5. To save space, we do not provide some results, such as those of unit root tests and diagnostic
tests. A working paper version of this paper, available upon request from the authors, contains all
the test results.

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 92  Emerging Markets Finance & Trade

Appendix A: Granger-Causality Test

Dependent Granger
Country Lags variable probability

Bulgaria 12 Inflation rate 0.000

Estonia 6 Output growth 0.005
Hungary 12 Inflation rate 0.001
Output growth 0.001
Latvia 12 Inflation rate 0.006
Lithuania 12 Inflation rate 0.034
Output growth 0.036
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Poland 12 Inflation rate 0.000

Output growth 0.015
Romania 12 Output growth 0.027
Russia 12 Output growth 0.000
Turkey 12 Inflation rate 0.040
Output growth 0.013
Ukraine 12 Output growth 0.016

Appendix B: Inflation and Output-Growth Equations

Country

Bulgaria Inflation equation

πt = 0.315 πt −1 + 0.026 yt − 4 + 0.029 yt − 5 + 0..158hπ t
( 3.60 ) ( 3.22 ) ( 4.09 ) ( 3.44 )

Output-growth equation
yt = − 0.097 yt −10 + 0.774 yt −12 − 0.303 hyt
( −2.17 ) (18.31) ( −2.78 )

Estonia Inflation equation

πt = 0.305 πt −1 + 0.121 πt −3 + 0.877 hπt
( 3.60 ) (1.99 ) ( 5.27 )

Output-growth equation
yt = 17.867 − 0.245 yt −1 + 0.233 yt −5 + 0.2339 yt −6 − 1.741 π t − 2 + 1.570 πt −3 − 1.038 πt − 5 − 0.990 hyt
( 7.46 ) ( −2.63 ) ( 2.76 ) ( 3.57 ) ( −3.49 ) ( 2.85 ) ( −2.17 ) ( −8.98 )

Hungary Inflation equation

πt = 5.318 + 0.265 πt −1 + 0.109 πt − 2 − 0.1177 πt − 6 + 0.156 πt −8 + 0.386 πt −12 + 0.010 yt − 4
( 4.57 ) ( 5.43 ) ( 2.19 ) ( −2.70 ) ( 3.18 ) (10.16 ) ( 3.14 )

− 0.012 yt − 9 + 5.318 hπt

( −3.52 ) ( 4.08 )

Output-growth equation
yt = −0.221 yt −1 − 0.302 yt −10 + 1.275π t − 5 − 0.002hyt
( −4.20 ) ( −4.23 ) ( 3.88 ) ( −1.97 )

Latvia Inflation equation

π t = 0.253 πt −1 + 0.167 πt −3 + 0.479 πt −12 + 0.030 yt −7 + 0.054 yt −8 + 0.030 yt −12 − 0.512 log hπ t
( 3.53 ) ( 3.00 ) ( 6.63 ) ( 2.78 ) ( 3.93 ) ( 2.92 ) ( −2.03 )

Output-growth equation
yt = − 0.319 yt −1 + 0.159 yt −3 + 0.515 log hπt
( −3.47 ) ( 2.29 ) ( 3.27 )
 July–August 2014, Volume 50, Supplement 4  93

Country

Lithuania Inflation equation

πt = 0.212 πt − 5 + 0.159 π t −6 + 0.243 πt −12 + 0.016 yt −9 + 0.013 yt −10 + 0.597 log hπ t
( 3.03 ) ( 2.43 ) ( 3.44 ) ( 3.26 ) ( 3.22 ) ( 2.01)

Output-growth equation
yt = − 0.650 yt −1 − 0.499 yt − 2 − 0.451 yt − 3 − 0.492 yt − 4 − 0.485 yt − 5 − 0.431 yt − 6 − 0.501 yt − 7
( −8.21) ( −6.27 ) ( −4.75 ) ( −5.32 ) ( −5.09 ) ( −4.49 ) ( −5.39 )

− 0.505 yt −8 − 0.365 yt − 9 − 0.324 yt −10 − 0.219 yt −11 + 1.396 πt − 2 − 2.806 πt − 9 + 0.099 hyt
( −4.68 ) ( −3.63 ) ( −3.24 ) ( −2.63 ) ( 2.92 ) ( 5.74 ) ( 5.62 )

Poland Inflation equation

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πt = 3.801 + 0.304 πt −1 + 0.139 πt − 4 − 0.1511 πt − 5 + 0.274 πt −12 + 0.020 yt − 6 + 0.029 yt − 7

( 4.56 ) ( 5.52 ) ( 2.57 ) ( −2.76 ) ( 6.80 ) ( 5.28 ) ( 6.08 )

+ 0.021 yt −8 + 1.046 hπt

( 5.00 ) ( 5.79 )

Output-growth equation
yt = −0.402 yt −1 − 0.346 yt − 2 − 0.144 yt − 3 − 0.228 yt − 4 − 0.121 yt − 9 − 0.274 yt −10
( −8.99 ) ( −6.95 ) ( −2.93 ) ( −4.97 ) ( −2.69 ) ( −6.30 )

− 0.198 yt −11 + 0.430 yt −12 + 0.190 πt −8 + 0.070 hyt

( −4.08 ) ( 9.42 ) ( 2.92 ) ( 3.15 )

Romania Inflation equation

πt = 0.440 πt −1 + 0.214 πt −6 + 0.089 πt −10 − 0.095 hπt
( 8.54 ) ( 4.72 ) ( 2.30 ) ( −3.99 )

Output-growth equation
yt = −0.266 yt −1 − 0.137yt − 2 − 0.191 yt − 3 − 0.137 yt − 9 − 0.204 yt −10 − 0.153 yt −11 + 0.603 yt −12
( −6.21) ( −3.04 ) ( −4.30 ) ( −3.48 ) ( −4.30 ) ( −3.47 ) (11.27 )

− 0.275 πt − 3 + 0.309 πt − 5 − 0.217 π t − 6 + 0.127 πt −8 + 0.003 hyt

( −3.92 ) ( 2.75 ) ( −2.14 ) ( 2.25 ) ( 2.00 )

Russia Inflation equation

πt = −0.136 πt −1 + 0.190 πt − 4 − 0.164 π t −8 + 0.138 πt −12 + 0.795 hπt
( −3.16 ) ( 3.28 ) ( −6.93 ) (10.54 ) ( 26.66 )

Output-growth equation
yt = −0.109 yt −10 − 0.096 yt −11 + 0.715 yt −12 − 0.835 πt − 4 + 0.296 πt −8 − 0.009 hyt
( −3.09 ) ( −2.80 ) ( 22.95 ) ( −18.93 ) ( 7.29 ) ( −12.13 )

Turkey Inflation equation

πt = 0.617 πt −1 + 0.272 πt −5 + 0.200 πt −11 + 0.034 yt −6 + 0.018 yt −7 − 0.047 yt −9 + 0.277 log hπ t
(17.66 ) ( 7.18 ) ( 5.82 ) ( 6.48 ) ( 3.23 ) ( −10.45 ) ( 2.17 )

Output-growth equation
yt = −0.181 yt −10 + 0.647 yt −12 + 0.348πt − 4 − 0.234 hyt
( −5.17 ) ( 23.59 ) ( 3.09 ) ( −2.06 )

Ukraine Inflation equation

πt = 0.596 πt −1 − 0.155 πt − 4 + 0.156 πt −9 − 0.192 πt −10 + 0.232 πt −11 + 2.066 log hπ t
( 7.88 ) ( −2.23 ) ( 2.12 ) ( −2.57 ) ( 2.54 ) ( 3.53 )

Output-growth equation
yt = 0.897 yt −12 + 0.523 πt − 6 − 1.727 log hπt
( 20.39 ) ( 2.29 ) ( −210.54 )

Note: t-statistics are in parentheses.

 94  Emerging Markets Finance & Trade

Appendix C: Inflation- and Output-Growth-Uncertainty Equations

Inflation-uncertainty Output-growth-uncertainty
Country equations equations

Bulgaria hπt = −0.017 − 0.046 ⋅ ε2π,t −1 + 1.038 ⋅ hπ,t −1 hyt = 873.99 + 0.080 ε2y ,t −1 − 0.915hy ,t −1
( −0.28 ) ( −747 ) (141) ( 9.00 ) ( 3.04 ) ( −19.33 )

Estonia hπt = 9.522 + 0.002ε 2

π ,t −1
− 1.007hπ,t −1 hyt = 31.696 + 0.079ε 2
y ,t −1 + 1.476 hy ,t −1
(11.35 ) ( 0.52 ) ( −112 ,85 ) ( 5.20 ) ( 3.37 ) ( 26.67 )

Hungary hπt = 0.128 − 0.043 ⋅ ε 2

π ,t −1
+ 1.103 ⋅ hπ,t −1 hyt = 864.413 − 0.101ε 2
y ,t −1 + 0.657hy ,t −1
( 9.02 ) ( −8.96 ) ( 413 ) ( 2.84 ) ( −2.56 ) ( 4.46 )

Latvia hπt = 0.235 + 0.097ε 2

+ 0.861hπ,t −1 hyt = 10.659 + 0.196 ε 2
+ 0.734 hy ,t −1
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π ,t −1 y ,t −1
(1.98 ) ( 2.65 ) ( 9.46 ) (1.98 ) ( 2.27 ) ( 7.82 )

Lithuania hπt = 1.201 + 0.211ε2π,t −1 + 0.60 hπ,t −1 hyt = 33.83 − 0.075ε2y ,t −1 + 1.030 hy ,t −1
(1.95 ) ( 2.14 ) ( 2.89 ) ( 4.33 ) ( −7132 ) (135 )

Poland hπt = 0.068 − 0.039ε 2

π ,t −1
+ 1.004 hπ,t −1 hyt = 733 − 0.025ε 2
y ,t −1 − 0.933hy ,t −1
(19.50 ) ( −70.10 ) (1140 ) (10.82 ) ( −2.37 ) ( −21.23 )

Romania hπt = 0.671 + 0.397ε 2

π ,t −1
+ 0.667hπ,t −1 hyt = 47.83 + 0.269ε 2
y ,t −1 + 0.636 hy ,t −1
( 2.06 ) ( 4.76 ) (13.62 ) ( 2.32 ) ( 2.98 ) ( 7.88 )

Russia hπt = 3.663 + 1.681ε 2

π ,t −1
+ 0.099hπ,t −1 hyt = 562.344 + 0.020 ε 2
y ,t −1 − 1.019hy ,t −1
( 3.18 ) ( 21.98 ) ( 2.09 ) (15.60 ) ( 3.73 ) ( −183 )

Turkey hπt = 6.177 + 0.3902ε 2

π ,t −1
+ 0.209hπ,t −1 hyt = 685.50 + 0.444 ε 2
y ,t −1 − 0.083hy ,t −1
( 3.57 ) ( 2.30 ) (1.36 ) ( 6.39 ) ( 3.53 ) ( −2.73 )

Ukraine hπt = 5.715 + 0.883ε 2

π ,t −1
− 0.046hπ,t −1 hyt = 741.60 + 0.158ε 2
y ,t −1 − 1.0406 hy ,t −1
( 3.24 ) ( 2.82 ) ( −1.26 ) ( 9.77 ) ( 3.91) ( −78 )

Note: t-statistics are in parentheses.