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United Kingdom Inflation Targeting and the Exchange Rate

  • Christopher Allsopp
  • Amit Kara
  • Edward Nelson

The UK's monetary policy strategy is one of floating exchange rates and inflation forecast targeting, with the targeted measure referring to consumer prices. We consider whether it is welfare-reducing to target inflation in the CPI rather than in a narrower index and the role of the exchange rate in the transmission of monetary policy actions to CPI inflation. It is appropriate to model imports as intermediate goods rather than goods consumed directly by households. This leads to a simpler transmission mechanism of monetary policy while also offering a sustainable explanation of the weakness of the exchange rate/inflation relationship and making consumer price inflation an appropriate monetary policy target. Copyright 2006 Royal Economic Society.

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Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): 116 (2006)
Issue (Month): 512 (06)
Pages: F232-F244

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Handle: RePEc:ecj:econjl:v:116:y:2006:i:512:p:f232-f244
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  1. Sbordone, Argia M., 2002. "Prices and unit labor costs: a new test of price stickiness," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 265-292, March.
  2. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
  3. Amit Kara & Edward Nelson, 2002. "The Exchange Rate and Inflation in the UK," Discussion Papers 11, Monetary Policy Committee Unit, Bank of England.
  4. Taylor, John B., 2000. "Low inflation, pass-through, and the pricing power of firms," European Economic Review, Elsevier, vol. 44(7), pages 1389-1408, June.
  5. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
  6. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  7. Wilson, Thomas, 1976. "Effective Devaluation and Inflation," Oxford Economic Papers, Oxford University Press, vol. 28(1), pages 1-24, March.
  8. Jose Manuel Campa & Linda S. Goldberg, 2002. "Exchange rate pass-through into import prices: a macro or micro phenomenon?," Staff Reports 149, Federal Reserve Bank of New York.
  9. McCallum, Bennett T & Nelson, Edward, 2000. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," Oxford Review of Economic Policy, Oxford University Press, vol. 16(4), pages 74-91, Winter.
  10. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  11. M.B. Devereux & Ch. Engel, 2003. "Exchange Rate Pass-Through, Exchange Rate Volatility, and ExchangeRate Disconnect," DNB Staff Reports (discontinued) 77, Netherlands Central Bank.
  12. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 199-216, March.
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