Inflation Dynamics and Business Cycles

The paper aims to investigate whether the effect of the backward-looking inflation expectations, nominal effective exchange rate, money supply, gross domestic product and import prices on inflation depends on business cycle. For this purpose, a two states Markov Switching Auto Regression model with time varying transition probabilities to a generic inflation model is implemented for the period 2003-2013. In this model the states are assigned whether output gap is positive or negative. The inflation forecasting in-sample and out-of-sample is also utilized by adopting mean squared error and Diebold Mariano test to measure explanatory and forecasting power of our model. Our main finding provides that the determinants of inflation have different dynamics during boom periods as compared to recessions