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Business School Research Memorandum 42 • October 2003

An Analysis of Interest Rate Determination in the UK and Four Major Leading Economies

KESHAB R BHATTARAI Centre for Economic Policy

Research Memorandum 42 • Oct 2003

An Analysis of Interest Rate Determination in the UK and Four Major Leading Economies

KESHAB R BHATTARAI Centre for Economic Policy The University of Hull Business School, Hull, HU6 7RX, UK. Email: [email protected]

ISBN 1 902034 35X

Abstract This paper reviews the fundamentals of the natural rate of unemployment, dynamic time inconsistency and policy co-ordination hypotheses that were behind the adoption of the interest rate rules by monetary authorities in recent years. Then it presents a simple Taylor rule of interest determination and its analytical solution using the second-order difference equation technique. The model is estimated using quarterly time series data on inflation, output and the interest rate for the UK from 1970:2 to 1999:4 and annual data series for five major economies from 1978 to 2000. In both cases we find evidence for such interest rules and the changes in the interest rate to have significant impacts on output, unemployment and inflation. It is shown that the simultaneous equation method better predicts the actual interest rate than the single equation method applied to each individual economy or to the global economy constructed by pooling cross section and time series of these individual economies.

Key words: Inflation, interest rate, growth, monetary policy JEL Classification: E3 and E4

Research Memorandum • 42 • The University of Hull Business School

3

I. Introduction The Monetary Policy Committee of the Bank of England determines the basic interest rate considering the overall macroeconomic situation in the UK and the global economy. The Committee has had operational independence since 1997. Similarly the European Central Bank, the Federal Reserve and the Bank of Japan determine interest rates frequently for their respective jurisdictions. What sort of macroeconomic models can explain such interest rate decisions and how do such decisions influence economic activities at home and abroad are issues of interest to a wide range of economic decision makers including households, firms, investors and traders in these economies. Here we present a brief background on the evolution of such a rule based on policy making over the last three decades and test the standard interest rate determination rule proposed by Taylor (1993) and others and discuss if the actual interest rates in the UK and five major economies in the world are close enough to the prediction of the model.

Background for an Interest Determination Model It is generally believed that the central banks raise the interest rate when the economy is experiencing inflationary pressure to choke off the aggregate demand, and lower it when the economy is slowing down in order to stimulate spending by households and firms. There has been a long history of research on this topic as reflected in works of (Keynes (1936), Hicks (1937), Bailey(1956) Phillips (1958), Friedman (1968), Phelps (1968), Tobin (1969)) Taylor (1972) Laidler and Parkin (1975) Kydland and Prescott (1977), Phelps and Taylor (1977) Aghevli (1977), Gordon (1983), Barro and Gordon (1983), Sargent (1986) Goodhart (1989), Ball and Romer (1990), Nickell (1990), Brainard and Nordhaus (1991), Buiter and Patel (1992), Dornbusch (1992, 1977, 1993), Bencivenga and Smith (1993), Barro (1995), Briault (1995), Fry (1995), Lockwood Miller and Zhang (1998), Vickers (1999), MPC (1999),Hall, Walsh and Yates (2000)). The fundamental ideas behind the Taylor rule emerge from the natural rate of unemployment hypothesis (Friedman (1968) and Phelps (1968)), which states that the money supply can influence output and employment only in the short run but not in the long run. If policy makers peg monetary policy to a level lower than the natural rate of unemployment, it only raises the actual and expected prices setting a motion of wage price spiral in the economy. It may lead to an expectation trap (Eichenbaum (1997)). In other words, it is impossible to achieve an unrealistically lower rate of unemployment by means of an expansionary monetary policy. The natural rate of unemployment represents frictional unemployment that depends on job separations and job finding rates. It helps the dynamic adjustment process in a growing economy. An unemployment rate above the NIARU is certainly a cause of concern. Given the expectation augmented Phillips curve π t = α (u t − u N ) + π te , where α < 0 , the trade-off between inflation and unemployment or output for the short run can be expressed as:

π t > π te ⇒ u t < u N ⇒ y t > y * π t < π te ⇒ u t > u N ⇒ y t < y * π t = π te ⇒ u t = u N ⇒ y t = y *

4

(1)


where π t is the actual inflation, π te is the expected inflation, u N is the natural rate of unemployment that is ground out by the Walrasian system of the general equilibrium, * u t is the actual unemployment rate, y t is the actual output and y is the natural rate of output. The underlying debate between an active or discretionary monetary policy vs. the Taylor, McCallum or any other rules for the monetary policy arises from the possibility of real impacts of demand management policy due to an inertia or inflexibility in the labour and goods markets either for reasons of staggered wage contracts or for menu costs or for long term sale-purchase agreement in the goods market (Taylor (1972), Mankiw (1985, 1987), Ball and Romer (1990), Driffil (1988), Eichenbaum (1997)). The expected inflation influences aggregate supply and aggregate demand, first through its impacts in the labour market and, secondly, through its influence on future expectations. In terms of a simple macro economic model these relations can be expressed in terms of the following six equations. A Cobb-Douglas aggregate production function Yt = N tα in logs y t = αnt

(2)

were Yt is output, N t is labour input, α is the elasticity of output with respect to the labour input, α > 0 . Demand for labour in equilibrium where the real wage rate equals the marginal productivity of labour: ∂Yt ∂N t = αN tα −1 = Wt Pt where Pt is the price level, Wt is the nominal wage rate. Taking log it can be written as:

wt − pt = ln(α ) + (α − 1)nt

(3)

Aggregate demand shows link between money supply, price level and output as M t Pt = k t Yt where k t is a monetary policy parameter; k t = eθ t where θ t is a random variable and M t is money supply. Now taking the logarithm of this demand:

mt − pt = ln(k t ) + y t or mt − p t = θ t + y t

(4)

Labour supply depends on expected real wage rate, w p e . If workers’ expected prices are lower than the actual prices p e < p , producers will find it cheaper to employ more labour by raising wages slightly, which workers take to be real rise in wages, w p e > w p e . This happens because workers know their nominal wage rate when they receive payments from their employment and expected prices from their own experience but they do not know the actual price level. The labour supply depends on expected real wage rate where the expectations about the current price level are conditional upon information available up to period t-1.

[{

}

nts = γ wt − Et*−1 ( pt ) / I t −1

]


(5)

5

where Et*−1 ( pt ) is the psychological expectation of the period t price level based on information available up to period t-1. The labour market clearing condition requires that labour supply equals labour demand in equilibrium, nts = n td which implies 1

γ

nts = wt − E t*−1 ( pt )

(6)

Assuming prices equal to the wage rate, pt = wt and solving (5) for the equilibrium value of labour input, the balance between demand and supply side of the labour market requires: 1

γ

nts − wt + E t*−1 ( pt ) = 0 = ln (α ) + (α − 1)nt − wt + pt

Equilibrium value of labour supply is obtained by rearranging terms: 1

γ

nts + (1 − α )nt = ln (α ) + pt − Et*−1 ( pt )

⎤ ⎡1 nt ⎢ + (1 − α )⎥ = pt − Et*−1 ( p t ) + ln (α ) ⎦ ⎣γ ⎡1

⎤

⎣γ

⎦

let Ω = ⎢ + (1 − α )⎥ Equilibrium employment nt =

[

]

1 pt − Et*−1 ( pt ) + ln (α ) Ω

(7)

yt =

and equilibrium output

α

[p Ω

t

]

− Et*−1 ( pt ) + ln(α )

(8)

Aggregate Supply, Inflation and Unemployment in the Short Run LAS

π >π

π =π

π y u> un u = un u< un y< y

(u−un )


Figure 1: Inflation Unemployment and Output LAS D1

yt =

D0 c p t > E t*−1 ( p t )

α Ω

[p

SAS: t

]

− E t*−1 ( pt ) + ln (α )

b

D2 a

p t − E t*−1 ( p t )

d

p t < E t*−1 ( p t )

f

yt < y *

y* =

α Ω

ln (α )

AD: y t = mt − p t − θ t

yt > y *

Figure 2: Aggregate Demand and Aggregate Supply Two facts from Figures 1 & 2 are noteworthy. First, it is possible for monetary policy to have real impacts in the short run until the long run adjustments take effect. The economy may move from point a to b or to d in the short run in response to positive or negative shocks in the aggregate demand. Secondly, these short run gains or losses will disappear after the economy moves back to its potential natural output level y * , only leaving their impact on the price level. Monetary policy cannot influence the economy in the long run, rather it can destabilise it by raising or lowering the aggregate demand in the short run. When the relative prices are disturbed it is difficult for an economic agent to take optimal decisions for consumption and production as he/she is unable to isolate changes in the relative prices from the changes in the aggregate price level. Inflation creates social tension by redistributing income from less to more wealthy people and from lenders to borrowers. Moreover such temporary measures may give rise to a notorious time inconsistency and credibility problem in the monetary policy (Sargent and Wallace (1975)). Adoption of an active public policy to exploit the possibility of short run trade-offs between unemployment and inflation under Friedman-Phelps-Taylor type natural rate of output and employment model have given rise to dynamic time inconsistency theories in the last two decades (Kydland and Prescott (1977), Barro and Gordon (1983), Rogoff (1985), Miller and Salmon (1985)). It has prompted literature on central bank independence and policy co-ordination models (Cukierman (1994), Goodhart (1994), Nordhaus (1995), Hanson (1980) Eijffinger and Haan (2000)). The main propositions of these various models remain that the government has an incentive or temptation to pursue a higher inflation strategy because it reduces the real value of outstanding debt, or lowers the cost of debt servicing, or makes it easier to finance the budget deficit. The inflation rate and the social costs of inflation and output gap are higher in the discretionary regime than under the policy rule. Research Memorandum • 42 • The University of Hull Business School

7

Furthermore, government has an incentive to cheat the public by a surprise or unanticipated inflation when people expect a zero or lower rate of inflation. Such a cheating strategy cannot last long as people will find out, sooner or later, that they were fooled by the government. This destroys the reputation of government about its commitment to a low inflation policy. Credibility in public announcements deteriorates. Workers and unions revise their expected prices. This ultimately triggers a wage price spiral which might prove detrimental to the health of the economy. This possibility of dynamic inconsistency in economic policy has given rise recently to a thriving literature on central bank independence with monetary rules such as the Taylor or McCallum rules. There is also more emphasis on policy co-ordination between fiscal and monetary authorities at national as well as at international levels (Krugman (1979), Barro and Gordon (1983), Canzoneri M. B. and J A Gray (1985), Nordhaus (1994), Altig, Carlstrom and Lansing (1995), Lockwood Miller and Zhang (1998), Corsetti and Pesenti (2001), Benigno (2002), HM Treasury (2002), Ireland (1994) and De Anne (1998)). All these new open or closed economy models emphasise credibility and consistency in the fiscal and monetary policy as well as how the fiscal-monetary policy mix could be obtained by delegating the inflation controlling role to an independent central bank that systematically adopts a Taylor type rule for the interest rate to achieve a target inflation rate.

II. A Simple Model for the Determination of the Interest Rate The short term interest rate is a key instrument of a monetary authority. Ways in which changes in it affect market rates, asset prices, expectations and exchange rates and - through these prices - the aggregate demand and inflation is discussed in detail in the literature on the transmission mechanism of the monetary policy (MPC (1999), Bernanke and Miskin (1997), Alesina and Summers (1993), Agenor et.al (1999)). Changes in the interest rate have profound impacts on saving and consumption behaviours of households, investment and capital accumulation behaviour of firms, and portfolio allocation of domestic and foreign trade in the financial and exchange rate markets. These changes affect the overall demand and supply position in the economy. These changes may occur immediately or over a lag of up to two years. They may also change expectations of these economic events about the future prospects of the economy. Serious welfare and redistribution impacts follow. Analysis of all these far reaching consequences of a change in the interest rate by the central bank require a more detailed model of the economy, which is beyond the scope of the current paper. Both econometric and general equilibrium models are found in the literature (Holly and Weale (2000), Altig, Carlstrom and Lansing (1995)). Here our focus is only to find out whether a type of Taylor rule can explain variations in the movements in the interest rate in the UK and five major industrial economies in the last three decades.

The Taylor rule model, that we use here, includes mainly three equations. The first equation states the current output gap y t − y * , the actual output relative to the trend output, as a function of the deviation of the interest rate one period earlier from the target interest rate of the monetary authority it −1 − i * . We expect this relationship to be negative because higher interest rates, by slowing down expenses by consumers and firms, have a contractionary impact in the economy. This relation can be presented as:

(

)

(

8

)


(

y t − y t * = −d it −1 − it*−1

)

d >0

(9)

where y t and y t* are actual and natural level of output, it is the actual rate of interest in period t, and it* is the interest target of the monetary authority. There is a one period lag between the interest rate decision and the change in the output. The expectation augmented Phillips curve in terms of output can be written as:

π t = π t* + c(y t −1 − yt*−1 )

c>0

(10)

where π t and π t* are actual and target inflation rates. When output is above the trend in the last period it creates pressure in the labour market which raises the wage rate. Increase in the wage rate translates into higher prices and higher rate of inflation. Policy makers like to reduce interest rate when both output and inflation rates are higher. Therefore the interest rate determination rule in simple terms can be written as

(

) (

it = it* + a y t − y t* + b π t − π t*

)

a > 0 ;b > 0

(11)

If we substitute out the output gap from (9) and the inflation rate gap from (10) in the interest rate rule in (11) we can see the cycles of interest rates emerging from the reduced form of these three equations (9) – (11).

(

)

(

it = it* − ad it −1 − it*−1 − bcd it −2 − it*− 2

)

it + adit −1 + bcdit − 2 = it* + adit*−1 + bcdit*− 2

(12)

The stability or convergence properties of this second order difference equation essentially depends upon the values of the parameters a b, c and d and two initial conditions for i0 and i1 . For simplicity let us define β 0 = it* + adit*−1 + bcdit*− 2 , and β 1 = ad and β 2 = bcd . Then equation (12) can be written as:

(

i t + β 1i t −1 + β 2 i t − 2 = β 0

)

(13)

The general solution to the reduced form equation (13) has complementary and particular parts. The particular solution refers to the steady state and the complementary solution shows a dynamic adjustment towards that steady state when the interest rate is above or below its natural rate. It explains the dynamics. The convergence or divergence from the steady state depends on this part of the equation. The particular or steady state solution is easy. In the steady state, interest rate equals the natural rate and is equal for each period, it = it +1 = it + 2 = ... = it + n . Let us denote this steady state or natural rate value as: it* + adit*−1 + bcdit*− 2 it* + adit*−1 + bcdit*− 2 with flexible targets and i= ;i= 1 + β1 + β 2 1 + ad + bcd


9

it* + adit* + bcdit* with fixed targets i= 1 + ad + bcd

(14)

Any perturbations from this natural rate should ultimately return to it due to forces of demand and supply in the financial markets. Transition from the steady state is represented by a homogeneous solution:

it + β 1it −1 + β 2 it − 2 = 0

(15)

Now the complementary solutions can have three different cases depending on the values of parameters β 0 , and β 1 and β 2 (a) real and distinct roots if β 12 − 4 β 2 > 0 (b) real and equal roots case if β 12 − 4 β 2 = 0 (c) complex roots case if β 12 − 4 β 2 < 0 . The general solutions of the model in these three different cases are : it = A1λ1t + A2 λt2 + i

(16)

where A1 and A2 are arbitrary constants and λ1t and λt2 are the characteristic roots. In case (a) the value of λ1t =

− β 1 + β 12 − 4 β 2

2 Therefore the general solution (7) can be written as:

⎛ − β + β 2 − 4β 1 1 2 it = A1 ⎜ ⎜ 2 ⎝

and λt2 =

t

2 ⎛ ⎞ ⎟ + A ⎜ − β1 − β1 − 4β 2 2 ⎜ ⎟ 2 ⎝ ⎠

− β 1 − β 12 − 4 β 2 2

.

t

⎞ ⎟ + i (17) ⎟ ⎠

More specifically using all the parameters of the model this turns to be ⎛ − ad + it = A1 ⎜ ⎜ ⎝

2

t

⎛ ad − + A2 ⎜ ⎜ ⎟ ⎝ ⎠

(ad )2 − 4bcd ⎞⎟

(ad )2 − 4bcd ⎞⎟ 2

⎟ ⎠

t

+i

(18)

The definite solution requires values of constant terms A1 and A2 , which can be obtained using the two initial conditions, i0 and i1 . Values of a, b, c and d parameters can be obtained from an econometric estimation with proper use of the target interest rate. Other two cases were considered but not reported here.

10


III. Data Set We use the macroeconomic time series data for the UK economy available from the Essex data archive. Here we present only the series for the retail price index, growth rate of the real GDP and the treasury bill rates which represent the whole varieties of

G r o w th r a t e o f o u tp u t, in t e r e s t r a t e a n d t h e t h e r e t a il p r ic e in d e x in U K 30

25

R PI G G D P T B IL L S

15

10

5

1999Q1

1997Q4

1996Q3

1995Q2

1994Q1

1992Q4

1991Q3

1990Q2

1989Q1

1987Q4

1986Q3

1985Q2

1984Q1

1982Q4

1981Q3

1980Q2

1979Q1

1977Q4

1976Q3

1975Q2

1974Q1

1972Q4

1971Q3

0 1970Q2

Percent per annum

20

-5

-1 0 Q u a rte rs

interest rate from 1970:q2 to 1999:q4. Figure 3 Figure 3: Growth rate of output, interest rate and inflation rate in the UK Figure 3 shows that fluctuations in the interest, inflation and the growth rates were more serious in 1980s than in 1990s but the UK economy has been stabilised towards its natural rate after 1995. A similar pattern can be obtained from analysis of the annual data on growth rates, output, inflation and interest rates for Germany, France, Japan, UK and the USA from 1978 to 2000 to study whether such interest rate rule existed during that period.


11

Real Interest Rates in Major Industrial Economies 15

rus rjp rgr rfr ruk

Percent Per Year

10

5

0 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20

-5

-10

Figure 4: Interest rates in Germany, France, Japan, UK and the US

IV. Analysis of Results We use above data set to test the interest rate determination model as outlined in the previous section. The econometric counter parts of equations (1) - (3) outlined above also include identically and independently distributed random error terms.

(

)

y t − y t* = d it −1 − it*−1 + ε 1,t

π t = π t* + c( y t −1 − y t*−1 ) + ε 2,t

(

) (

(18)

)

it = it* + a y t − y t* + b π t − π t* + ε 3,t

(19) (20)

We use a recursive estimation and simultaneous equation method to estimate this model. In the recursive estimation method first we estimate the output gap as a function of the lagged interest rate, then inflation gap on the lagged output gap and finally the interest rate rule using the predicted values of the output gap and inflation gaps estimated from the above equations. Note however that there is simultaneity among these variables, the output gap is influenced by the interest rate, and the inflation gap is determined by the output gap and then that is determined by the interest rate. Therefore application of the OLS in one single equation produces a biased result. A simultaneous equation method is required in order to eliminate this bias. This fact is evident from the estimation of these equations presented using the Shazam (1997) software. First we estimate equations (9), (10) and (11) individually. In equation (19) the coefficient of the Phillips curve is significant and has the expected sign but the overall explanatory power of the estimated equation is very minimal. There is also evidence for a positive autocorrelation. Similarly from equation (10) the coefficient of the output gap on the interest rate differential and that of inflation gap on output gap have expected signs but they are not significant. Again Durbin Watson statistics shows an evidence for a positive autocorrelation. Therefore estimates obtained using a single equation method are not reliable.

12


Interest Rate Determination Model: 18

PTBIL TBILLS

16 14 12 10 8 6 4 2 0

0

20

40

60 TIME

80

100

120

Figure 5: Actual and predicted series of interest rates Phillips’ Curve: U = 9.42 -0.250 RPI t-ratios (18.05) (18.05) R-SQUARE = 0.1588 DW = 0.56

Output and the interest rate y t − y t * = −0.185 it −1 − it*−1

(

)

(21)

d >0

(22)

t-ratio (-1.54) R-SQUARE = 0.0199 Output and inflation π t − π t* = 0.129 y t −1 − y t*−1 c>0

(

)

t-ratios (0.982) R-SQUARE = DURBIN-WATSON = 0.127 Interest rate rule it = 9.25 + 2.70 y t − y t* − 2.76 π t − π t*

(

)

t-ratios

(

(32.0)

(3.97)

(23)

0.0082

)

(24) (-3.38)

R = 0.18 Durbin-Watson = 0.2065 2

The single equation method failed because of a simultaneity bias across equations. This problem is avoided when we use a simultaneous equation method either by using a reduced form second order difference equation (13) for estimation or a vector autoregressive model that takes account of simultaneity bias. All coefficients of the reduced form equation and the VAR model have expected signs. The first explains up to 62 percent of the overall variation and the second explains even more, 86 percent of the variation in the interest rate.


13

Estimation of the second order difference equation for the interest rate:

it = 1.630 + 0.582it −1 + 0.244it − 2 t-ratios (2.71) (6.42)

(25) (6.69)

R-SQUARE = 0.62 DURBIN-WATSON = 2.0104

Simultaneous equation estimation: VAR method Interest rate i = 4.969(y-y*) -5.182 (p-p*)

(26)

(7.74) (-7.27) Output gap: y-y* = 0.08i + 0.504 (p-p*)

(27)

(7.75) (5.21) Inflation: p-p* = -0.071i + 0.421 (y-y*) (-7.27) (5.21) SYSTEM R-SQUARE =

(28)

0.8637

The result of the simultaneous equation model has better overall fit. Now the model explains about 86 percent of variation in the interest rate. The fit of the predicted and the actual interest rate is almost perfect as shown in the figures below. Figure 6a-6c Interest Rate Determination Rule : A Simultaneous Equations Estimation 25

15

PTBIL TBILLS

20

8

PDY DY

6

15

PDRPI DRPI

10

4

5

10

2

-2

0

-5 -4

-5

-6

-10

0

0

5

0

20

40

60 TIME

80

100

120

0

20

40

60 TIME

80

100

120

-10

0

20

40

60 TIME

Now estimate the interest rule model given by (18)-(20) for five major industrial economies: France, Gernamy, Japan, UK and USA using the annual data set on growth rates of output, inflation and interest rates obtained from the World Bank (2002). As before we follow three steps in applying this interest rate determination model to those five major industrial economies. First we predict current output gap as a function of the actual interest rates in the previous period relative to a trend interest rate, and the current inflation gap as a function of output gap in the previous period. Secondly, we use these predicted series of output and inflation gaps to estimate the model generated interest rate for each period. Finally, we compare the series of the actual interest rates to those predicted by the model. As Table 1 shows, these model predictions track actual interest rates very well and divide the sources of changes in the interest rate into the real or supply side factors as represented by the output gap and the demand side factors as represented by the inflation gaps.

14


80

100

120

Table 1 Test of Interest Determination Rule for Five Major Economies (Estimates from a 3SLS method) Output gap -6.641 (-14.778) -10.732 (-15.187) -6.775 (-6.554) -2.941 (-5.885) -1.794 (-7.061)

France Germany Japan UK USA

Inflation gap 0.670 (1.341) 4.335 (4.953) -1.794 (-7.061) 1.006 (2.848) 0.360 (0.408)

Constant 5.900 (1.341) 5.339 (11.898) -1.312 (-3.487) 7.416 (10.203) 5.337 (18.955)

R2 0.766 0.752 0.641 0.574 0.696

Values in the parenthesis represent t-statistics. The explanatory power of this model in analysing the behaviour of the interest rate in each economy is quite remarkable as shown by higher values of R-square statistics. The size of the coefficients of output gap vary substantially across these countries reflecting the link between the interest rate and growth rate of the economy. These output gap coefficients are significant for each of the above countries at one percent level of significance as shown by the t-statistics. These economies reduce the interest rate whenever the actual output growth rate is below the trend growth rate and increase it whenever the actual growth rate is above the trend growth rate in order to avoid inflationary consequences. There is dissimilarity, however, regarding the link between the interest rate and inflation gap among these countries both in terms of size of coefficients and its significance. All countries except Japan have the expected sign of the coefficient on the inflation gap but that is not significant for the US. Despite this, the predictive power of each equation remarkably suggests the existence of the interest rate rule among these economies during the study period. We also studied the interdependence of the interest rate determination rule among these five major economies by treating them as one economy and pooling cross section and time series data for 1978-2000.

(

)

(

it = 6.25 − 0.29 y t − yt* + 0.115 π t − π t* t-ratios

(0.80)

(-3.30)

)

(29) (1.33)

R = 0.43 F = 5.5; N=100 2

Though both output gap and inflation gap have the expected signs with regard to the interest rate, these estimates suggest that when we consider these five economies together as one global economy, there is more concern for the real output fluctuation rather than for the control of the inflation rate. It suggests that taken as a whole in Research Memorandum • 42 • The University of Hull Business School

15

these economies the importance attached to the lower inflation is secondary to that given to the lower unemployment rate and higher rate of growth of output further confirming the results as reported in Domenech et.al. (2002). Analysis of how the interest rate affects the whole economy requires more detailed specification of demand, production, portfolio allocation and trade structure of the monetary economy in line with Tobin (1969), Altig, Carlstrom and Lansing (1995) and Corsetti and Pesenti (2001). This could be the next stage of research in this topic.

V. Conclusion A natural rate of unemployment hypothesis together with dynamic time inconsistency and credibility, and policy co-ordination at the national and international level, gave rise to the prominence to the role of central bank independence and rule based monetary policy aimed to achieve pre-set inflation targets in the major industrial economies. We have presented a simple model for interest determination and found its analytical solution using the second order difference equation technique and estimated this model using time series data on treasury bills rate, growth rate of output and inflation rates series for the UK economy and for five major industrial economies during the last three decades. We found evidence both for such an interest rule and support to the hypothesis that the interest changes too have significant impacts on output, unemployment and inflation in our estimation. We also found that this model can better predict the actual interest rate when it is estimated using the simultaneous equation technique rather than when it is estimated using only the single equation technique.

16


References Agenor, P.R. et al. eds. (1999) The Asian Financial Crisis: Causes, Contagion and Consequences, Cambridge University Press.

Aghevli B B (1977), Inflationary Finance and Growth, Journal of Political Economy, 85:6:1295-1307. Alesina A, L. H. Summers (1993) Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence Journal of Money, Credit and Banking, 25: 2: 151-162, May. Altig D E, C.T. Carlstrom and K.L. Lansing (1995) Computable General Equilibrium Models and Monetary Policy Advice, Journal of Money Credit and Banking, 27: 4:1472-1493: Nov. Bailey M J. (1956) The Welfare Cost of Inflationary Finance, Journal of Political Economy, LXIV:2:93-110, April. Ball L.and D. Romer (1990) Real Rigidities and the Non-Neutrality of Money, Review of Economic Studies, 57:183-203. Barro R.J. (1995) Inflation and Economic Growth, Bank of England Quarterly Bulletin, 35: 2: 166-175, May. Barro R.J. and D. B. Gordon (1983a) Rules, Discretion and Reputation in a Model of Monetary Policy, Journal of Monetary Economics, 12: 101-121, North-Holland. Barro R.J. and D. B. Gordon (1983b) A Positive Theory of Monetary Policy in a Natural Rate Model, Journal of Political Economy, vol. 91:4: 589-610. Bencivenga V. R. and B.D. Smith (1993) Economic development and financial depth in a model with costly financial intermediation, Research in Economics, 52:363-386. Benigno, Pierpaolo (2002) A Simple Approach to International Monetary Policy Coordination; Journal of International Economics, 57:1: 177-96, June. Bernanke B. S. and F.S. Mishkin (1997) Inflation Targeting: A New Framework for Monetary Policy, Journal of Economic Perspectives, vol. II:2:97-116, Spring. Brainard, W. and Nordhaus, S, (1991) Money, Macroeconomics and Economic Policy: Essays in Honor of James Tobin, MIT Press, Cambridge, MA. Briault C. (1995) The Cost of Inflation, Bank of England Quarterly Bulletin, pp. 3345, February. Buiter W. H. and U R Patel ( 1992) Debt, deficit and inflation: An application to the public finances of India, Journal of Public Economics, 47:171-205, North Holland.


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Canzoneri M. B. and J A Gray (1985) “Monetary Policy Games and the Consequences of Non-Cooperative Behaviour”, International Economic Review, 26:3: 547-567. Corsetti, G and P.Pesenti; (2001) Welfare and Macroeconomic Interdependence; Quarterly Journal of Economics, May, v. 116, iss. 2, pp. 421-45 Cukierman A.(1994) Policy Forum: The Banking System and Monetary Control Central Bank Independence and Monetary Control The Economic Journal, 104:427:1437-1448 November DeAnne, J. (1998) Inflation and growth in a service economy, Bank of England Quarterly Bulletine, pp. 338-346, November. Domenech R, M. Ledo and D. Taguas (2002) Some New Results on Interest Rate Rules in EMU and in the US, Journal of Economics and Business, 54:431-446. Dornbush, R. (1992) Lessons from Experiences with High Inflation, World Bank Economic Review, 6:1:13-31. Driffil J. (1988) Macroeconomic Policy Games with Incomplete Information: A Survey, European Economic Review, 32 (2-3) 513-41. Eichenbaum (1997) Some Thoughts on Practical Stabilisation Policy, American Economic Review, 87:2:236-239. Eijffinger SCW and J.D. Haan (2000) European Monetary and Fiscal Policy, Oxford University Press. Fisher, S. (1977) Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule, Journal of Political Economy, 85:1:191-205, February. Friedman, M (1968) The Role of Monetary Policy, American Economic Review, vol. LVIII 58:1:1-17, , March . Fry, M.J.(1995) Money, Interest, and Banking in Economic Development, 2nd edition, The John Hopkins University Press, Baltimore. Goodhart C. (1989) The Conduct of Monetary Policy, Economic Journal, 99: pp. 293346, June. Goodhart C.E.A. (1994a) What should central banks do? What should be their macroeconomic objective and operations?, Economic Journal, 104:1424-1436, November. Goodhard C AE (1994b) Game Theory for Central Bankers: A Report to the Governor of the Bank of England, Journal of Economic Literature, XXXII: pp.101115, March.

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Gorden R.J. (1990) What is New-Keynesian Economics? Journal of Economic Literature, 28: 1115-1171, September. Hall S. M.Walsh and A. Yates (2000) Are UK companies price sticky?, Oxford Economic Papers 52, 425-446. Hanson J A (1980) The Short Run Relation Between Growth and Inflation in Latin America: A Quasi-Rational or Consistent Expectations Approach, The American Economic Review, 70:5: 972-989, December. Hicks, J. R. (1937) Mr. Keynes and the “Classics”: A Suggested Interpretation, Econometrica, 5:1:147-159. HM Treasury (2002) “UK Model of Central Bank Independence: An Assessment” in Reforming Britain’s Economic and Financial Policy, Palgrave pp. 85109.http://www.fsa.gov.uk/ Holly S and M Weale Eds.(2000) Econometric Modelling: Techniques and Applications, pp.69-93, Cambridge University Press. Ireland P N (1994) Money and Growth: An Alternative Approach, American Economic Review, 84: 1: 47-65, March. Keynes J.M. (1936) The General Theory of Employment, Interest and Money, MacMillan Cambridge University Press. Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit and Banking, 11,Aug. Kydland, F. E. and E.C. Prescott (1977) Rules Rather than Discretion: The Inconsistency of Optimal Plans, Journal of Political Economy 85: 3: 473-491. Laidler D and M Parkin (1975) Inflation: A Survey, The Economic Journal, 85: 340: 741-809December. Lucas R.E. (1976) Econometric Policy Evaluation: A Critique, Carnegie Rochester Conference Series on Public Policy 1: 19-46. Lockwood, Ben; Miller, Marcus; Zhang, Lei (1998) Designing Monetary Policy When Unemployment Persists Economica, August, 65: 259:pp. 327-45 Mankiw G. N. (1985) Small Menu Costs and large Business Cycles: A Macroeconomic Model of Monopoly, Quarterly Journal of Economics, pp.529-537. Mankiw G.N. (1987) The Optimal Collection of Seigniorage, Journal of Monetary Economics, 20, 327-341, North Holland. Mankiw, G.N., D. Romer, and D.N. Weil (1992) A Contribution to the of Economic Growth Quarterly Journal of Economics, 107:407-438.


Empirics

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Miller M and M. Salmon (1985) Dynamic Games and the Time Inconsistency of Optimal Policy in Open Economies, The Economic Journal, Vol. 95, Supplement: Conference Papers. pp. 124-137. MPC (1999) The Transmission Mechanism of Monetary Policy, Bank of England (www.bankofengland.co.uk). Nickell, S. (1990), “Inflation and the UK Labour Market” Oxford Review of Economic Policy; 6(4) Winter. Nordhaus W. D. (1995) Policy Games: Co-ordination and Independence in Monetary and Fiscal Policies, Brookings Papers on Economic Activity 2:1994: 139-216. Phelps E. S. (1968) Money wage dynamics and labour market equilibrium, Journal of Political Economy, 76: 678-711. Phelps E. S. and J.B. Taylor (1977) Stabilisation Powers of Monetary Policy underRational Expectations, Journal of Political Economy, 85:1:163-190. Phillips A W. (1958) The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957. Rogoff K. (1985) Can International Monetary Policy Cooperation Be Counterproductive? Journal of International Economics, 18 199-217, North Holland. Sargent, T. J. (1986) Rational Expectation and Inflation, Harper and Row Publishers, New York. Sargent, T. J. and N. Wallace (1975) “Rational” Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule, Journal of Political Economy, pp. 41-254. Shazam (1997) User’s Reference Manual, Version 8, Shazam ~997-1873 East Mall, Vancouver, B.C. V6T 1Z1, Canada. http://shazam.econ.ubc.ca/. Taylor J B (1972) Staggered Wage Setting in a Macro Model, American Economic Review, 62:1-18. Taylor J (1993) Discretion versus policy rules in practice, Carnegie Rochester Conference Series on Public Policy 29 Amsterdam. Tobin, J (1969), A general Equilibrium Approach to Monetary Theory, Journal of Money Credit and Banking, pp. 15-29. Vickers J (1999), Inflation Targeting in the UK, Bank of England Quarterly Bulletin, pp. 368-375.

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Research Memoranda published in the HUBS Memorandum Series Please note that some of these are available at: http://www.hull.ac.uk/hubs/research/memoranda

*Keshab R Bhattarai (no. 41 – Oct 2004) (Part of the Hull Economics Research Paper Series: 287) Macroeconomic Impacts of Consumption and Income Taxes: A General Equilibrium Analysis *Juan Paez-Farrell (no 40 – July 2003) (Part of the Hull Economics Research Paper Series: 286) Business Cycles in the United Kingdom: An Update on the Stylised Facts *Juan Paez-Farrell (no 39 – July 2003) (Part of the Hull Economics Research Paper Series: 285) Endogenous Capital in New Keynesian Models Philip Kitchen, Lynne Eagle, Lawrence Rose and Brendan Moyle (no. 38 – 2003) The Impact of Gray Marketing and Parallel Importing on Brand Equity and Brand Value Marianne Afanassieva (no. 37 – 2003) Managerial Responses to Transition in the Russian Defence Industry José-Rodrigo Córdoba-Pachón and Gerald Midgley (no. 36 – 2003) Addressing Organisational and Societal Concerns: An Application of Critical Systems Thinking to Information Systems Planning in Colombia *Joanne Evans and Richard Green (no. 35 – 2003) (Part of the Hull Economics Research Paper Series: 284) Why did British Electricity Prices Fall After 1998? Christine Hemingway (no. 34 – 2002) An Exploratory Analysis of Corporate Social Responsibility: Definitions, Motives and Values Peter Murray (no. 33 – 2002) Constructing Futures in New Attractors Steven Armstrong, Christopher Allinson and John Hayes (no. 32 – 2002) An Investigation of Cognitive Style as a Determinant of Successful Mentor-Protégé Relationships in Formal Mentoring Systems Norman O'Neill (no. 31 – 2001) Education and the Local Labour Market Ahmed Zakaria Zaki Osemy and Bimal Prodhan (no. 30 – 2001) The Role of Accounting Information Systems in Rationalising Investment Decisions in Manufacturing Companies in Egypt

Andrés Mejía (no. 29 – 2001) The Problem of Knowledge Imposition: Paulo Freire and Critical Systems Thinking Patrick Maclagan (no. 28 – 2001) Reflections on the Integration of Ethics Teaching into the BA Management Degree Programme at The University of Hull Norma Romm (no. 27 – 2001) Considering Our Responsibilities as Systemic Thinkers: A Trusting Constructivist Argument L. Hajek, J. Hynek, V. Janecek, F. Lefley, F. Wharton (no. 26 – 2001) Manufacturing Investment in the Czech Republic: An International Comparison Gerald Midgley, Jifa Gu, David Campbell (no. 25 – 2001) Dealing with Human Relations in Chinese Systems Practice Zhichang Zhu (no. 24 – 2000) Dealing With a Differentiated Whole: The Philosophy of the WSR Approach Wendy J. Gregory, Gerald Midgley (no. 23 – 1999) Planning for Disaster: Developing a Multi-Agency Counselling Service Luis Pinzón, Gerald Midgley (no. 22 – 1999) Developing a Systemic Model for the Evaluation of Conflicts Gerald Midgley, Alejandro E. Ochoa Arias (no. 21 – 1999) Unfolding a Theory of Systemic Intervention Mandy Brown, Roger Packham (no. 20 – 1999) Organisational Learning, Critical Systems Thinking and Systemic Learning Gerald Midgley (no. 19 – 1999) Rethinking the Unity of Science Paul Keys (no. 18 – 1998) Creativity, Design and Style in MS/OR Gerald Midgley, Alejandro E. Ochoa Arias (no. 17 – 1998) Visions of Community for Community OR Gerald Midgley, Isaac Munlo, Mandy Brown (no. 16 – 1998) The Theory and Practice of Boundary Critique: Developing Housing Services for Older People John Clayton, Wendy Gregory (no. 15 – 1997) Total Systems Intervention of Total Systems Failure: Reflections of an Application of TSI in a Prison

Luis Pinzón, Néstor Valero Silva (no. 14 – 1996) A Proposal for a Critique of Contemporary Mediation Techniques – The Satisfaction Story Robert L Flood (no. 13 – 1996) Total Systems Intervention: Local Systemic Intervention Robert L Flood (no. 12 – 1996) Holism and the Social Action 'Problem Solving' Peter Dudley, Simona Pustylnik (no. 11 – 1996) Modern Systems Science: Variations on the Theme? Werner Ulrich (no. 10 – 1996) Critical Systems Thinking For Citizens: A Research Proposal Gerald Midgley (no. 9 – 1995) Mixing Methods: Developing Systems Intervention Jane Thompson (no. 8 – 1995) User Involvement in Mental Health Services: The Limits of Consumerism, the Risks of Marginalisation and the Need for a Critical Approach Peter Dudley, Simona Pustylnik (no. 7 – 1995) Reading the Tektology: Provisional Findings, Postulates and Research Directions Wendy Gregory, Norma Romm (no. 6 – 1994) Developing Multi-Agency Dialogue: The Role(s) of Facilitation Norma Romm (no. 5 – 1994) Continuing Tensions Between Soft Systems Methodology and Critical Systems Heuristics Peter Dudley (no. 4 –1994) Neon God: Systems Thinking and Signification Mike Jackson (no. 3 – 1993) Beyond The Fads: Systems Thinking for Managers

Previous Centre for Economic Policy Research Papers

Joanne Evans and Richard Green (no. 284/35 – January 2003) Why did British Electricity Prices Fall after 1998? Naveed Naqvi, Tapan Biswas and Christer Ljungwall (no. 283 – July 2002) Evolution of Wages and Technological Progress in China’s Industrial Sector Tapan Biswas, Jolian P McHardy (no. 282 – May 2002) Productivity Changes with Monopoly Trade Unions in a Duopoly Market Christopher Tsoukis (no. 281 – January 2001) Productivity Externalities Tobin’s Q and Endogenous Growth Christopher J Hammond, Geraint Johnes and Terry Robinson (no. 280 – December 2000) Technical Efficiency Under Alternative Regulatory Regimes: Evidence from the InterWar British Gas Industry Christopher J Hammond (no. 279 – December 2000) Efficiency in the Provision of Public Services: A Data Envelopment Analysis of UK Public Library Systems Keshab Bhattarai (no. 278 – December 2000) Efficiency and Factor Reallocation Effects and Marginal Excess Burden of Taxes in the UK Economy Keshab Bhattarai, Tomasz Wisniewski (no. 277 – Decembe 2000) Determinants of Wages and Labour Supply in the UK Taradas Bandyopadhay, Tapan Biswas (no. 276 – December 2000) The Relation Between Commodity Prices and Factor Rewards Emmanuel V Pikoulakis (no. 275 – November 2000) A “Market Clearing” Model of the International Business Cycle that Explains the 1980’s Jolian P McHardy (no.274 – November 2000) Miscalculations of Monopoly and Oligopoly Welfare Losses with Linear Demand Jolian P McHardy (no. 273 – October 2000) The Importance of Demand Complementarities in the Calculation of Dead-Weight Welfare Losses Jolian P McHardy (no. 272 – October 2000) Complementary Monopoly and Welfare Loss

Christopher Tsoukis, Ahmed Alyousha (no. 271 – July 2000) A Re-Examination of Saving – Investment Relationships: Cointegration, Causality and International Capital Mobility Christopher Tsoukis, Nigel Miller (no. 270 – July 2000) A Dynamic Analysis of Endogenous Growth with Public Services Keshab Bhattarai (no. 269 – October 1999) A Forward-Looking Dynamic Multisectoral General-Equilibrium Tax Model of the UK Economy Peter Dawson, Stephen Dobson and Bill Gerrad (no. 268 – October 1999) Managerial Efficiency in English Soccer: A comparison of Stochastic Frontier Methods Iona E Tarrant (no 267 – August 1999) An Analysis of J S Mill’s Notion of Utility as a Hierarchical Utility Framework and the Implications for the Paretian Liberal Paradox Simon Vicary (no. 266 – June 1999) Public Good Provision with an Individual Cost of Donations Nigel Miller, Chris Tsoukis (no. 265 – April 1999) On the Optimality of Public Capital for Long-Run Economic Growth: Evidence from Panel data Michael J Ryan (no. 264 – March 1999) Data Envelopment Analysis, Cost Efficiency and Performance Targetting Michael J Ryan (no. 263 – March 1999) Missing Factors, Managerial Effort and the Allocation of Common Costs

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