Monetary Policy, Beliefs, Unemployment and Inflation; Evidence from the UK

Recent applied macroeconomic research has been concerned with the effects of<br />

both labour market reforms and the delegation of monetary policy to an inflation-averse<br />

central bank as ways of improving inflation and unemployment outcomes. The experience of<br />

the UK over the recent past following the introduction of changes to the labour market in the<br />

1980s and of inflation targeting and instrument independence for the Bank of England in the<br />

1990s, has often been held up as illustrations of the beneficial effects of regime changes of<br />

this sort. Others have contradicted these views, including those who have drawn attention to<br />

the weakness in the empirical evidence favouring effects from labour market reforms, and<br />

others who argue that a combination of beneficial international events and monetary policy<br />

mistakes have played an important part in the U.K.'s recent successes.<br />

We review the case for regime change from either of these sources; labour market and<br />

monetary, in an application to the U.K using an model which integrates both. The results<br />

indicate two things; the importance of allowing for the openness of the UK economy in<br />

'behavioural' econometric models of the natural rate, and the importance of allowing for<br />

policy 'mistakes'. Based on our analysis, we conclude that recent changes in UK monetary<br />

policy or the labour market institutions seem unlikely to have made an important contribution<br />

to the improvements in UK economic performance. Effects originating overseas appear to<br />

play an important role in unemployment changes in the U.K. Policy mistakes appear to have<br />

had important effects on inflation over the last two decades, and a proper allowance for these<br />

is needed before any firm judgements of the benefits of monetary policy delegation can be<br />

reached.<br />