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UK Macroeconomic Volatility and the Welfare Costs of Inflation

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  • Vito Polito
  • Peter Spencer

Abstract

This paper explores the implications of time varying volatility for optimal monetary policy and the measurement of welfare costs. We show how macroeconomic models with linear and quadratic state dependence in their variance structure can be used for the analysis of optimal policy within the framework of an optimal linear regulator problem. We use this framework to study optimal monetary policy under inflation conditional volatility and find that the quadratic component of the variance makes policy more responsive to inflation shocks in the same way that an increase in the welfare weight attached to inflation does, while the linear component reduces the steady state rate of inflation. Empirical results for the period 1979-2010 underline the statistical significance of inflation-dependent UK macroeconomic volatility. Analysis of the welfare losses associated with inflation and macroeconomic volatility shows that the conventional homoskedastic model seriously underestimates both the welfare costs of in‡ation and the potential gains from policy optimization.

Suggested Citation

  • Vito Polito & Peter Spencer, "undated". "UK Macroeconomic Volatility and the Welfare Costs of Inflation," Discussion Papers 11/21, Department of Economics, University of York.
  • Handle: RePEc:yor:yorken:11/21
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    References listed on IDEAS

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    Cited by:

    1. Spencer, Peter & Liu, Zhuoshi, 2010. "An open-economy macro-finance model of international interdependence: The OECD, US and the UK," Journal of Banking & Finance, Elsevier, vol. 34(3), pages 667-680, March.

    More about this item

    Keywords

    Monetary policy; Macroeconomic volatility; Optimal control; Welfare costs of inflation.;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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