Monetary Policy and Stagflation in the UK

Abstract

The volatile behavior of inflation, output, and interest rates in the United Kingdom prior to the 1990s helps discriminate between rival explanations for the outbreak of stagflation. We examine alternative hypotheses with a New Keynesian model of aggregate demand and inflation determination, estimated on quarterly UK data for 1959-2000. Our model features IS and Phillips curves based on optimizing behavior, and fully incorporates the distinction between detrended output and the output gap stressed by optimizing analysis. Using simulations of our model as well as information on the "real-time" views of policymakers, we test alternative explanations for the outbreak of inflation in the United Kingdom in the 1960s and 1970s. We find that inaccurate estimates of the degree of excess demand in the economy contributed significantly to the outbreak. But we also find a major role for the failure at the time to recognize the importance of monetary policy, as opposed to nonmonetary devices, in controlling inflation.JEL codes: E31, E52, E58

International comovements in inflation rates and country characteristics

“…In contrast, Romer and Romer (2002) implicitly argue that the Fed used a fairly sophisticated but deeply flawed model that claimed to offer an exploitable inflationunemployment tradeoff. Nelson (2005aNelson ( , 2005b and Nelson and Nikolov (2004) argue that "monetary neglect"demphasis on non-monetary factors in inflationdlargely explains the Great Inflation not only in the United States but also in Canada, Australia, New Zealand, and the United Kingdom.…”

Robust inflation-forecast-based rules to shield against indeterminacy

“…Priors for the risk-aversion and labor supply parameters, s and f, respectively, are shaped in the form of a Gamma density and are chosen to be fairly flat, reflecting the wide dispersion of existing empirical estimates and calibrations of these parameters in the literature (see Nelson and Nikolov, 2002).…”

Drifting inflation targets and monetary stagflation

“…While the economy contracted sharply in 1982, inflation had fallen by more than 3 percentage points from the previous year and was trending down. The years 1976The years , 1977The years , and 1978 1 Iain Macleod, who is usually recognized as the creator of the term, defined stagflation as "not just inflation on the one side or stagnation on the other, but both of them together" (Nelson and Nikolov, 2004). 2 The figure is slightly affected if GDP growth and inflation are computed using annual data instead of using fourth-quarter over fourth-quarter percentage changes.…”