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Does high M4 money growth trigger large increases in UK inflation? Evidence from a regime-switching model

  • Costas Milas

    ()

    (Keele University, UK and The Rimini Centre for Economics Analysis, Rimini, Italy.)

March 2007 saw an increase of 3.1 percent in the Consumer Price Index (CPI) annual inflation rate and triggered the first explanatory letter from the Governor of the Bank of England to the Chancellor of the Exchequer since the Bank of England was granted operational independence in May 1997. The letter gave rise to a lively debate on whether policymakers should pay attention to the link between inflation and M4 money growth. Using UK data since the introduction of inflation targeting in October 1992, we show that: (i) the relationship between inflation and M4 growth is not stable over time, and (ii) the tendency of M4 to exert inflationary pressures is conditional on annual M4 growth exceeding 10%. Above this threshold, a 1 percentage point increase in the annual growth rate of M4 increases annual inflation by only 0.09 percentage points, whereas a 1 percentage point increase in the disequilibrium between money and its long-run determinants increases annual inflation by only 0.07 percentage points. Since the money effects are very small, the implication is that the Monetary Policy Committee should not be particularly worried for not paying close attention to M4 money movements when setting interest rates.

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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 25-07.

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Date of creation: Jul 2007
Date of revision: Jul 2007
Handle: RePEc:rim:rimwps:25-07
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