Monetary targets, exchange rate targets and after: a stochastic "hard-landing" for sterling?

This paper describes three distinct phases of UK exchange rate policy in the 1980's (monetary targeting with free floating of the early 80's, exchange rate targeting of the mid 80's and the current "pragmatic" approach) and indicates the likely reasons for the switches in policy. The demise of monetarism has been generally attributed to the instability of the velocity of money; and we argue that it was the strength of domestic demand (especially by consumers) which was to a large extent responsible for the ending of the experiment in shadowing the DM. We note that the policy stance pursued subsequently by Mr Lawson as Chancellor involved driving interest rates far above those in West Germany while keeping sterling reasonably steady against the DM. To reconcile this with free currency arbitrage, we argue that UK interest rates contained a risk premium reflecting the market belief that, come the end of the consumer boom, the Government will allow sterling to fall as a means of achieving current account adjustment.