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The Exchange Rate and Inflation in the UK

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  • Kara, Amit
  • Nelson, Edward

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, focusing 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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3783.

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Date of creation: Feb 2003
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Handle: RePEc:cpr:ceprdp:3783

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Keywords: cpi inflation targeting; exchange-rate pass-through; intermediate goods; monetary policy rules; UK inflation;

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Citations

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Cited by:
  1. Alessandro Flamini, 2004. "Inflation Targeting and Exchange Rate Pass-Through," IHEID Working Papers 04-2004, Economics Section, The Graduate Institute of International Studies.
  2. Peter Tinsley & Sharon Kozicki, 2003. "Alternative Sources of the Lag Dynamics of Inflation," Computing in Economics and Finance 2003 92, Society for Computational Economics.
  3. Patrizio Tirelli & V. Anton Muscatelli & Carmine Trecroci, 2004. "The interaction of fiscal and monetary policies: some evidence using structural econometric models'," Money Macro and Finance (MMF) Research Group Conference 2003 103, Money Macro and Finance Research Group.
  4. V. Anton Muscatelli & Patrizio Tirelli & Carmine Trecroci, 2004. " Fiscal and Monetary Policy Interactions in a New Keynesian Model with Liquidity Constraints," CDMA Conference Paper Series 0402, Centre for Dynamic Macroeconomic Analysis.
  5. Campbell Leith & Jim Malley, 2007. "Estimated Open Economy New Keynesian Phillips Curves for the G7," Open Economies Review, Springer, vol. 18(4), pages 405-426, September.
  6. Colin Bermingham, 2006. "Employment and Inflation Responses to an Exchange Rate Shock in a Calibrated Model," The Economic and Social Review, Economic and Social Studies, vol. 37(1), pages 27-46.
  7. Bermingham, Colin, 2005. "Employment and Inflation Responses to an Exchange Rate Shock in a Calibrated Model," Research Technical Papers 2/RT/05, Central Bank of Ireland.
  8. Christopher Allsopp & Amit Kara & Edward Nelson, 2006. "U.K. inflation targeting and the exchange rate," Working Papers 2006-030, Federal Reserve Bank of St. Louis.
  9. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
  10. Lim, G. C. & McNelis, Paul D., 2004. "Learning and the monetary policy strategy of the European Central Bank," Journal of International Money and Finance, Elsevier, vol. 23(7-8), pages 997-1010.
  11. Janko Gorter, 2005. "Subjective Expectations and New Keynesian Phillips Curves in Europe," DNB Working Papers 049, Netherlands Central Bank, Research Department.
  12. V. Anton Muscatelli & Tiziano Ropele & Patrizio Tirelli, 2004. "Macroeconomic Adjustment in the Euro-area: The Role of Fiscal Policy," Working Papers 2005_20, Business School - Economics, University of Glasgow, revised May 2005.
  13. Christopher Martin & Michael Arghyrou & Costas Milas, 2004. "Nonlinear inflation dynamics: evidence from the UK," Money Macro and Finance (MMF) Research Group Conference 2003 59, Money Macro and Finance Research Group.
  14. Christopher Allsopp, 2002. "Macroeconomic Policy Rules in Theory and in Practice," Discussion Papers 10, Monetary Policy Committee Unit, Bank of England.
  15. Rebecca Driver & Stephen Millard, 2004. "Exchange rates, commodities and the implications of volatility in a small open economy world," Money Macro and Finance (MMF) Research Group Conference 2003 26, Money Macro and Finance Research Group.

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