Inflation uncertainty and real economic activity: an alternative approach

Increased uncertainty about inflation is shown to encourage inflation hedging which, in turn, reduces the macro-economic costs of that uncertainty. Portfolio theory and empirical evidence support the contention that only the portion of inflation volatility that cannot be hedged has real economic effects. Additional empirical results suggest that: (i) increased inflation volatility in the early seventies was eventually followed by portfolio reallocations that allowed for greatly improved inflation hedging, and (ii) the deleterious effect of inflation uncertainty on real economic activity shown in previous studies is significantly smaller after 1975.