Two essays on the link between inflation uncertainty and interest rates and effect of foreign income on economic performance of a small-open economy

Abstract

This study includes two studies on the relationship between inflation uncertainty and interest rates and examines the effects of foreign income on economic performance of a small open economy. In the literature, there is no consensus about the direction of the effects of inflation uncertainty on interest rates. The second chapter of this study states that such a result may stem from differentiation in the sources of the uncertainties and analyzes the effects of different types of inflation uncertainty on a set of interest rates for the UK within interest rate rule framework. Three types of inflation uncertainties – impulse uncertainty, structural uncertainty and steady-state uncertainty – are derived by using a time-varying parameter model with a Generalized Autoregressive Conditional Heteroskedasticity specification. It is shown that the impulse uncertainty is positively and the structural uncertainty is negatively correlated with the interest rates. Moreover, these two uncertainties are important to explain shortterm interest rates for the period of inflation targeting era. However, this time, the impulse uncertainty is negatively and the structural uncertainty is positively correlated with the overnight interbank interest rates, which is consistent with the general characteristic of the inflation targeting regimes. The evidence concerning the effect of the steady state inflation uncertainty on interest rates is not conclusive. The third chapter uses the same methodology of the second chapter and calculates the effects of those three types of inflation uncertainties on interest rate spreads. It is found that both the structural and steady-state inflation uncertainties increase interest rate spreads, while the empirical evidence for the impulse uncertainty is not conclusive. Finally, the last chapter examines how the changes in a large foreign economy affect the economic performance of a small country. It finds the values of effects by calculating impulse response functions of the domestic economy and confidence intervals for those functions. Turkey is chosen as the domestic economy and Germany, the US, and the industrial countries are used as proxies for the large economy. The results state that a positive shock in the foreign economy positively affects domestic economy, increases the inflation rates, and appreciates the real exchange rate.