The York Research Database

This paper uses a macro-finance model of the UK economy and Treasury bond market to examine the hypothesis of Okun (1971) and Friedman (1997) that macroeconomic volatility is linked to the rate of inflation. This approach models the economy and financial markets jointly and uses both economic and financial data to throw light on such issues. My econometric model is a development of the `square root volatility model' that was originally used to model the term structure of interest rates, but unlike the conventional term structure specification it allows for separate volatility and inflation trends. It shows that square root volatility is very significant in the UK economy. Although volatility and inflation move independently in the short run, they are cointegrated. Bond yields provide useful information about macroeconomic volatility, but a better indicator can be developed by combining this with macroeconomic information.