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Has More Independence Affected Bank of England's Reaction Function under Inflation Targeting? Lessons from Taylor Rule Empirics

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  • Alexander Mihailov

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Abstract

This paper is an empirical investigation into the question of whether increased independence affects central bank behavior, in particular when monetary policy is already in an inflation targeting regime. We take advantage of the unique experience in that sense of the United Kingdom, where the Bank of England was granted operational independence from Her Majesty's Treasury only in May 1997, while inflation targeting had been implemented since October 1992. Our strategy is to estimate Taylor rules employing alternative specifications, econometric methods and variable proxies in search for robust results that survive most of those modifications. The key lesson we extract from UK quarterly data is that the Bank of England has responded to the output gap, and not at all to output growth, the more so after receiving operational independence, when the gap has been positive or close to zero and inflation credibly stabilized at target. We find no unambiguous evidence for any definite change in the Bank's reaction to inflation or in the degree of its interest rate smoothing. Our main import is to argue that both the asymmetry of the monetary policy reaction function across the cycle and the response to the output gap, not growth, are fully consistent with New Keynesian theory, especially under inflation targeting. Anchored inflation and economic expansion during the post-independence period thus complement greater autonomy in influencing the behavior of the Bank of England, yet clear separation of the individual contribution of each of these effects appears challenging given our short sample.

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Paper provided by University of Essex, Department of Economics in its series Economics Discussion Papers with number 601.

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Date of creation: 11 Oct 2005
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Handle: RePEc:esx:essedp:601

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  1. Assessing the Blair years
    by chris dillow in Stumbling and Mumbling on 2007-04-10 12:53:08
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Cited by:
  1. Mihailov, Alexander & Ullrich, Katrin, 2007. "Independence and Accountability of Monetary and Fiscal Policy Committees," ZEW Discussion Papers 07-044, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  2. Costas Milas & Christopher Martin & Ram Sharan Kharel, 2007. "The Complex Response of Monetary Policy to the Exchange Rate," Working Paper Series 37-07, The Rimini Centre for Economic Analysis, revised Jul 2007.
  3. Martin, Christopher & Milas, Costas, 2010. "Financial Stability and Monetary Policy," Department of Economics Working Papers 19328, University of Bath, Department of Economics.
  4. Alexander Mihailov, 2005. "Operational Independence, Inflation Targeting and UK Monetary Policy," Economics Discussion Papers 602, University of Essex, Department of Economics.
  5. Philip Arestis & Alexander Mihailov, 2007. "Flexible Rules cum Constrained Discretion: A New Consensus in Monetary Policy," Economics & Management Discussion Papers em-dp2007-53, Henley Business School, Reading University.
  6. Boinet, Virginie & Martin, Christopher, 2010. "The optimal neglect of inflation: An alternative interpretation of UK monetary policy during the "Great Moderation"," Journal of Macroeconomics, Elsevier, vol. 32(4), pages 982-992, December.

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