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U.K. inflation targeting and the exchange rate

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  • Christopher Allsopp
  • Amit Kara
  • Edward Nelson

Abstract

The United Kingdom*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. We argue that it is appropriate to model imports as intermediate goods rather than as goods consumed directly by households. This leads to a simpler transmission mechanism of monetary policy, while also offering a sustainable explanation fore the weakness of the exchange rate/inflation relationship and making consumer price inflation an appropriate monetary policy target.

Suggested Citation

  • 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.
  • Handle: RePEc:fip:fedlwp:2006-030
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    References listed on IDEAS

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    1. 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.
    2. Amit Kara & Edward Nelson, 2003. "The Exchange Rate and Inflation in the UK," Scottish Journal of Political Economy, Scottish Economic Society, vol. 50(5), pages 585-608, November.
    3. Campa, Jose M. & Goldberg, Linda S., 2002. "Exchange rate pass-through into import prices: A macro or micro phenomenon?," IESE Research Papers D/475, IESE Business School.
    4. José Manuel Campa & Linda S. Goldberg, 2005. "Exchange Rate Pass-Through into Import Prices," The Review of Economics and Statistics, MIT Press, vol. 87(4), pages 679-690, November.
    5. 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.
    6. Jordi Galí & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
    7. Ben S. Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-128.
    8. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
    9. 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.
    10. Joseph E. Gagnon & Jane E. Ihrig, 2001. "Monetary policy and exchange rate pass-through," International Finance Discussion Papers 704, Board of Governors of the Federal Reserve System (U.S.).
    11. Vickers, John, 2000. "Monetary Policy and Asset Prices," Manchester School, University of Manchester, vol. 68(0), pages 1-22, Supplemen.
    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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    Citations

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    Cited by:

    1. Guender, Alfred V., 2008. ""Leaning with the wind"? An open-economy example," Journal of Macroeconomics, Elsevier, vol. 30(3), pages 941-964, September.
    2. Roger Bjørnstad & Eilev S. Jansen, 2007. "The NOK/euro exhange rate after inflation targeting: The interest rate rules," Discussion Papers 501, Statistics Norway, Research Department.
    3. David Cobham, 2006. "The Overvaluation of Sterling Since 1996: How the Policy makers Responded and Why," Economic Journal, Royal Economic Society, vol. 116(512), pages 185-207, June.
    4. Fan, Jingwen & Minford, Patrick, 2009. "Can the Fiscal Theory of the price level explain UK inflation in the 1970s?," Cardiff Economics Working Papers E2009/26, Cardiff University, Cardiff Business School, Economics Section, revised Mar 2011.
    5. Guender, Alfred V., 2011. "The timeless perspective vs. discretion: Theory and monetary policy implications for an open economy," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1638-1658.
    6. Lavan Mahadeva & Juan Carlos parra, 2008. "Testing a DSGE model and its partner database," BORRADORES DE ECONOMIA 004507, BANCO DE LA REPÚBLICA.
    7. Riccardo DiCecio & Edward Nelson, 2010. "Euro Membership as a U.K. Monetary Policy Option: Results from a Structural Model," NBER Chapters,in: Europe and the Euro, pages 415-439 National Bureau of Economic Research, Inc.
    8. Cover, James P. & Mallick, Sushanta K., 2012. "Identifying sources of macroeconomic and exchange rate fluctuations in the UK," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1627-1648.
    9. Horacio Aguirre & Tamara Burdisso, 2008. "Dangerous Liaisons? An Empirical Assessment of Inflation Targeting and Exchange Rate Regimes," BCRA Working Paper Series 200839, Central Bank of Argentina, Economic Research Department.

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    Keywords

    Inflation (Finance) - Great Britain ; Foreign exchange rates - Great Britain;

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