Academic journal article Journal of Money, Credit & Banking

The "Great Moderation" in the United Kingdom

Academic journal article Journal of Money, Credit & Banking

The "Great Moderation" in the United Kingdom

Article excerpt

ON OCTOBER 8, 1992, 3 weeks after sterling's departure from the Exchange Rate Mechanism of the European Monetary System, the Chancellor of the Exchequer, Norman Lamont, established the first direct inflation target in the history of the United Kingdom, as a range of 1-4% for annual RPIX (1) inflation. Since then, UK macroeconomic performance has been characterized by low and stable inflation, historically low interest rates, and, as of 2006 Q4, 56 quarters of uninterrupted output growth.

In previous research--see Benati (2004)--we used tests for multiple structural breaks at unknown points in the sample and band-pass filtering techniques, to investigate changes in UK economic performance since the end of WWII. Empirical evidence suggests the inflation-targeting regime to have been, in a very broad sense, significantly more stable than the previous post-WWII era. First, for both real GDP growth, and three alternative measures of inflation, we identified break dates around the time of the introduction of inflation targeting, in October 1992. For all four series, the estimated variance of reduced-form innovations over the most recent subperiod has been, so far, the lowest of the post-WWII era. Second, the volatility of the business-cycle components of macroeconomic indicators has been, after October 1992, almost always lower than either under Bretton Woods or during the 1971-92 period, often-as in the case of inflation and real GDP markedly so.

Benati (2006) extends the analysis backwards in time to the metallic standard era, documenting how the inflation targeting regime has been characterized, to date, by the most stable macroeconomic environment in recorded UK history, with the volatilities of the business-cycle components of real GDP, national accounts aggregates, and inflation measures having been, post-1992, systematically lower than for any of the previous monetary regimes/historical periods.

Where does such a remarkable and historically unprecedented stability come from? Providing an answer to this question is of obvious, crucial importance. If the bulk of the stability of the post- 1992 era were attributable to the impact of the new monetary framework, we then might be reasonably confident that macroeconomic instability was a memory of the past--with the right monetary policy in place, the 1970s could never return. If, on the other hand, the current stable macroeconomic environment found its origin in the fact that, in recent years, the UK economy has been spared the large shocks of previous decades, having the best possible monetary framework in place would not necessarily shield us from a reappearance of macroeconomic turbulence.

In this paper we use a Bayesian time-varying parameters structural VAR with stochastic volatility along the lines of Primiceri (2005), Canova and Gambetti (2005), and Gambetti, Pappa, and Canova (2006), to shed some light on the deep underlying causes of the Great Moderation in the United Kingdom. Our main objective is to evaluate the comparative likelihood of two main rival explanations/stories which have been advanced in the context of the debate on the stabilization of the U.S. economy under Alan Greenspan's tenure--the "good luck" versus "good policy" debate. Our main results may be summarized as follows.

* The evolution of the coefficients of the structural monetary rule in the VAR is broadly in line with the narrative evidence, (2) with, e.g., a comparatively weaker long-run response to inflation before 1979-80, a marked increase under Margaret Thatcher, and a further increase under inflation targeting. Interestingly, the period during which the United Kingdom was a member of the Exchange Rate Mechanism of the European Monetary System was characterized by significant temporary decreases in the long-run coefficients on both inflation, output growth, and the rate of growth of M4, thus dramatically highlighting how during that period UK monetary policy--being "done in Frankfurt" was virtually disconnected from domestic economic conditions. …

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