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The Exchange Rate and Inflation in the UK

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  • Amit Kara
  • Edward Nelson

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.

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Paper provided by Monetary Policy Committee Unit, Bank of England in its series Discussion Papers with number 11.

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Date of creation: 2002
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Handle: RePEc:mpc:wpaper:11

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Citations

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Cited by:
  1. Campbell Leith & Jim Malley, 2002. "Estimated Open Economy New Keynesian Phillips Curves for the G7," Working Papers 2002_8, Business School - Economics, University of Glasgow.
  2. Janko Gorter, 2005. "Subjective Expectations and New Keynesian Phillips Curves in Europe," DNB Working Papers 049, Netherlands Central Bank, Research Department.
  3. Campbell Leith & Simon Wren-Lewis, 2002. "Taylor Rules in the Open Economy," Discussion Papers 0203, Exeter University, Department of Economics.
  4. 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.
  5. 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.
  6. 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.
  7. Peter Tinsley & Sharon Kozicki, 2003. "Alternative Sources of the Lag Dynamics of Inflation," Computing in Economics and Finance 2003 92, Society for Computational Economics.
  8. Alessandro Flamini, 2004. "Inflation Targeting and Exchange Rate Pass-Through," IHEID Working Papers 04-2004, Economics Section, The Graduate Institute of International Studies.
  9. V. Anton Muscatelli & Tiziano Ropele & Patrizio Tirelli, 2004. "Fiscal and Monetary Policy Interactions in a New Keynesian Model with Liquidity Constraints," Working Papers 83, University of Milano-Bicocca, Department of Economics, revised Nov 2004.
  10. Christopher Allsopp, 2002. "Macroeconomic Policy Rules in Theory and in Practice," Discussion Papers 10, Monetary Policy Committee Unit, Bank of England.
  11. Benoît Mojon & Laure Frey, 2009. "Le dollar et l’inflation mondiale," Revue d'Économie Financière, Programme National Persée, vol. 94(1), pages 81-106.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. 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.

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