The Exchange Rate and Inflation in the UK

Abstract

The United Kingdom is a highly open economy, and has a monetary policy strategy of targeting inflation in consumer prices. In this paper, we look at the evidence from the UK on inflation behaviour, and examine the propositions from several theoretical models about inflation dynamics in an open economy, focussing in particular on the hypothesised connections between the exchange rate and consumer price inflation. Theoretical open-economy macroeconomic models 'cover the waterfront' on this issue, ranging from 'exchange rate disconnect' to a rigid link between nominal exchange rate changes and inflation. We estimate on UK data the open-economy Phillips curves implied by the alternative explanations. We argue that, of the alternatives considered, only a model where imports are modelled as an intermediate good, as in McCallum and Nelson (1999), provides a reasonable match with the data. Unlike the standard model, in which imports are treated as a final consumer good, the intermediate-goods specification provides support for a policy of CPI inflation targeting.

Estimating the New Keynesian Phillips Curve for the UK: evidence from the inflation-indexed bonds market

“…Gulyàs and Startz (2006) uses break-even inflation rate as a measure of expected inflation and find similar results. 21 In fact, Balakrishnan and Lopez-Salido (2002) and Kara and Nelson (2003) find that the relationship between marginal cost and inflation disappears in the mid-1980s in case of the UK. 22 Notice that the evidence from the 4-year spot rate does support these findings.…”

Monetary Policy and Inflation Performance: Evidence from Exchange Rate Regimes in Sri Lanka

“…Batini (2002) and Kara and Nelson (2002) also use similar definitions. Accordingly, type I inflation persistence is estimated using autocorrelation coefficient of price inflation process and different specifications of Phillips curve.…”

“…Second, an openness condition (∆reer t -E t ∆reer t+i ), is added to the standard closed economy NKPC specification followed by Kara and Nelson (2002). This relates to the difference between current real exchange rate depreciation relative to next period's expected real depreciation which accounts for the effects of changes in exchange rate depreciation on domestic consumer price inflation.…”

Determinants of Inflation Differentials in the Euro Area: Is the New Keynesian Phillips Curve Enough?

“…We expect that an appreciation of the euro, i.e., an increase in ∆e i,t , has a negative impact on inflation (γ e < 0). The expected and lagged values of exchange rate's change are introduced due to the assumption that expected and lagged domestic inflation affect present domestic inflation (Kara and Nelson, 2003). The lag and lead exchange rates coefficients are expected to be positive (γ ef and γ eb > 0).…”

“…The presence of the real exchange rate's level can be interpreted as national inflation rates acting to correct disequilibrium in that variable. Other possible interpretation is that with imported inputs in production, real exchange rate's level directly affects marginal cost (Kara and Nelson, 2003).…”