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

Recent applied macroeconomic research has been concerned with the effects of both labour market reforms and the delegation of monetary policy to an inflation-averse central bank as ways of improving inflation and unemployment outcomes. The experience of the UK over the recent past following the introduction of changes to the labour market in the 1980s and of inflation targeting and instrument independence for the Bank of England in the 1990s, has often been held up as illustrations of the beneficial effects of regime changes of this sort. Others have contradicted these views, including those who have drawn attention to the weakness in the empirical evidence favouring effects from labour market reforms, and others who argue that a combination of beneficial international events and monetary policy mistakes have played an important part in the U.K.'s recent successes. We review the case for regime change from either of these sources; labour market and monetary, in an application to the U.K using an model which integrates both. The results indicate two things; the importance of allowing for the openness of the UK economy in 'behavioural' econometric models of the natural rate, and the importance of allowing for policy 'mistakes'. Based on our analysis, we conclude that recent changes in UK monetary policy or the labour market institutions seem unlikely to have made an important contribution to the improvements in UK economic performance. Effects originating overseas appear to play an important role in unemployment changes in the U.K. Policy mistakes appear to have had important effects on inflation over the last two decades, and a proper allowance for these is needed before any firm judgements of the benefits of monetary policy delegation can be reached.