AN APPLICATION OF ARCH AND ARCH-M MODELS TO STUDY INFLATION IN MEXICO FROM 1978 TO 1999

Abstract

This paper analyzes the inflation process in Mexico, recognizing that the variance of inflation in Mexico changes over time (specifically in 1982, 1988, and 1994) and can be modeled following an ARCH (Autoregressive Conditional Heteroskedastic) model. We find that the inflation in Mexico follows an ARCH process from 1978 to 1999, and an ARCH-M process from 1989 to 1999. We also find that the process that better fits the conditional variance from 1978 to 1988 is an ARCH (2) , and from 1989 to 1999 an ARCH (1). In both periods, the exchange rate is significant in the conditional variance, and in the mean of the inflation. The significant variables to explain the inflation from 1978 to 1988 are two inflation lags, the exchange rate, and the money supply (Ml). These same variables, along with wages, are significant in explaining the inflation during 1989 to 1999.