Using auxiliary residuals to detect conditional heteroscedasticity in inflation

Abstract

In this paper we consider a model with stochastic trend, seasonal and transitory components with the disturbances of the trend and transitory disturbances specified as QGARCH models. We propose to use the differences between the autocorrelations of squares and the squared autocorrelations of the auxiliary residuals to identify which component is heteroscedastic. The finite sample performance of these differences is analysed by means of Monte Carlo experiments. We show that conditional heteroscedasticity truly present in the data can be rejected when looking at the correlations of observations or of standardized residuals while the autocorrelations of auxiliary residuals allow us to detect adequately whether there is heteroscedasticity and which is the heteroscedastic component. We also analyse the finite sample behaviour of a QML estimator of the parameters of the model. Finally, we use auxiliary residuals to detect conditional heteroscedasticity in monthly series of inflation of eight OECD countries. We conclude that, for most of these series, the conditional heteroscedasticity affects the transitory component while the long-run and seasonal components are homoscedastic. Furthermore, in the countries where there is a significant relationship between the volatility and the level of inflation, this relation is positive, supporting the Friedman hypothesis.