JOURNAL OF APPLIED ECONOMETRICS, VOL. 7, zyxwvut 131-148 (1992) THE RELATIONSHIP BETWEEN FORECAST DISPERSION AND FORECAST UNCERTAINTY: EVIDENCE FROM A SURVEY DATA-ARCH MODEL zyx R. W. RICH zyxwvu Department of Economics, Vanderbilt University, PO Box 1819, Station zyxw 3, Nashville, TN 37235, USA J. E. RAYMOND Department of Economics, Auburn University, zyxwvu 107 Thach Hall, Auburn, AL 36849, USA AND J. S. BUTLER Department of Economics, Vanderbilt University, PO Box 1819, Station B, Nashville, TN SUMMARY This paper examines empirically the relationship between measures of forecast dispersion and forecast uncertainty from data on inflation expectations from the Livingston survey series and the Survey Research Center (SRC) survey series. Because the survey series do not provide probabilistic forecasts of inflation, we derive measures of inflation uncertainty by modelling the conditional variance of the inflation forecast errors from the survey series as an autoregressive conditional heteroscedastic (ARCH) process. The analysis is complicated by the fact that the overlap of forecast horizons for the survey series does not preclude the model’s disturbance terms from displaying autocorrelation, and also places a restriction on the specification for the ARCH measures of inflation uncertainty. We estimate the model using Hansen’s (1982) generalized method of moments (GMM) procedure to account for the presence of serial correlation and conditional heteroscedasticity in the disturbance terms. The results generally support the hypothesis that the measures of forecast dispersion across survey respondents are positively and statistically significantly associated with the measures of inflation uncertainty. However, the appropriateness of using forecast dispersion measures as proxies for inflation uncertainty is sensitive to the choice of the survey series. 1. INTRODUCTION Assessing the effects of inflation on aggregate economic activity has been an issue of long- standing importance in macroeconomics. While previous attention was directed towards examining the neutrality of anticipated and unanticipated changes in inflation, there is now general agreement that changes in inflation uncertainty have significant real effects. Friedman (1977) argues that greater inflation uncertainty will be associated with higher levels of inflation, with increases in inflation uncertainty leading to a worsening in the allocation of resources due to the reduced efficiency of the price system. Lucas (1973, 1975) and Barro (1976), in equilibrium business cycle models with incomplete information, demonstrate that greater uncertainty about changes in the general price level reduces the ability of economic agents to perceive relative price changes, thereby impeding the adjustment of real variables to changes in tastes and technology. 0883-7252/92/02013 1 zyxwvutsrqp - 18$09.00 zyxwvu 0 1992 by John Wiley & Sons, Ltd. Received July I990 Revised September I991