UK Monetary Policy Reaction Functions, 1992-2014: A Cointegration Approach Using Taylor Rules.

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University of Huddersfield Repository

Ferga, Jumuaa UK Monetary Policy Reaction Functions, 19922014: A Cointegration Approach Using Taylor Rules. Original Citation Ferga, Jumuaa (2016) UK Monetary Policy Reaction Functions, 19922014: A Cointegration Approach Using Taylor Rules. Doctoral thesis, University of Huddersfield. This version is available at http://eprints.hud.ac.uk/id/eprint/28564/ The University Repository is a digital collection of the research output of the University, available on Open Access. Copyright and Moral Rights for the items on this site are retained by the individual author and/or other copyright owners. Users may access full items free of charge; copies of full text items generally can be reproduced, displayed or performed and given to third parties in any format or medium for personal research or study, educational or notforprofit purposes without prior permission or charge, provided: • The authors, title and full bibliographic details is credited in any copy; • A hyperlink and/or URL is included for the original metadata page; and • The content is not changed in any way. For more information, including our policy and submission procedure, please contact the Repository Team at: [email protected]. http://eprints.hud.ac.uk/

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UK Monetary Policy Reaction Functions, 1992-2014: A Cointegration

Approach Using Taylor Rules.

By

Jumuaa Ferga

A thesis submitted to the University of Huddersfield in partial fulfilment of

the requirements for the degree of Doctor of Philosophy

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Abstract

For more than two decades, monetary policy of countries around the world has undergone significant transformation. The long-term stabilization and lowering of inflation is the primary target of central banks founded on the principles of transparency and credibility. The achievement of inflation targeting and control is ultimately judged by the public’s expectations about future inflation. This objective has focused central bank policy making on modern monetary principles and the adoption of one of its core principles, the monetary policy rule.

The central bank of the United Kingdom officially adopted an explicit inflating targeting monetary policy in October 1992 following its operational independence in May 1997. In this study, we attempt to investigate the behaviour of the Central Bank of England under an inflation targeting framework. In other words, whether Taylor-type policy rules can be used to describe the behaviour of the Central Bank of England. We specifically attempt to shed light on the question does Taylor's rule (Taylor, 1993) adequately describes central bank behaviour? And whether the existence of formal targets has induced nonlinearity in this behaviour,beginning in October 1992 until December 2014.

The study uses time series estimations of Taylor-type reactions functions to characterise monetary policy conduct in the UK, we use time series data, because all the other studies in this area are using the time series method and recommended it, Osterholm (2005), Nelson (2000), Adam et al (2003), Clarida et al (2000) amongst others. In addition, this study uses a long database which is useful for time series analysis. The analysis uses a modified cointegration and error correction model that is robust to the stationary properties of the data as well as vector autoregression techniques; therefore, our methodology in this study employed three types of econometric tests namely: unit root tests, cointegration tests and error correction models. We used monthly data for the UK

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over the period October 1992 to December 2014, and we estimate Taylor-type policy rules for the UK in order to find answers to these questions.

Our results indicate that the Central Bank of England has not been following the Taylor rule. In other words, the regression results clearly indicated that the Central Bank of England did not follow the Taylor rule in the period 1992-2014. This is because all coefficients of inflation gap and the output gap were statistically insignificant. In addition, we conclude these results link with the New Consensus Macroeconomics, criticism of inflation targeting and endogenous money theory.

The main contribution in this study is an up-to-date analysis, and evidence that Bank of England policy does not work with Taylor rules. In addition, on the methodological level most previous studies reviewed in the literature have measured the interest rate, inflation and the output gap using one dependent variable, to measure the behaviour of the Central Bank of England, to assess whether the Taylor rule is effective or not. However, this study fills this gap by using two measure for interest rate, three measure for inflation and two variables to measure the output gap, using The Hodrick-Prescott (HP) filter and moving averages, to assess whether the Taylor rule is effective or not effective by using more than one dependent variable.

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Acknowledgements

First and more importantly, my deepest gratitude and appreciation go to almighty ALLAH; the merciful, the compassionate, for giving me the opportunity and the ability to complete this thesis. It is He who guided me to every success that I have had throughout my life.

I am greatly indebted with profound gratitude to my supervisor, Dr Shabbir Dastgir for his invaluable comments, long and interesting discussions, patience, kindness, and for effective guidance, valuable advice, useful comments, and encouragement and support throughout the research and the preparation of this thesis. Moreover, I want to thank him for his open door policy and for his reliability, these are things that make the life of a research student so much easier.

As well, I would like to thank Professor John Anchor, my second supervisor, for his valuable help.

I would also like to express my profound gratitude to my close relatives for their unlimited love, kindness and sympathy. My father and mother who were always praying to God to help me towards success and return home; my deepest gratitude and appreciation goes to my wife, Nagat , for her encouragement and patience. She motivated me to pursue my PhD, and accepted the many sacrifices that this has involved. Moreover, my wife Nagat who has taken, during my study, big share of the responsibility for looking after our children both in Britain and in Libya, I very grateful for her. I should also thank my kids, Mohamed, Muaad and Duaa, for their patience and for providing me with the spirit and hope for the future.

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ِميِحَّرلٱ ِن هم ْحَّرلٱ ِ هٰللّٱ ِمْسِب

( َقَل َخ يِذَّلا َكِّبَر ِمْساِب ْأَرْقا ﴿

1 ( ٍقَلَع ْنِم َناَسْنِلإا َقَلَخ )

2 ( ُمَرْكَلأا َكُّبَرَو ْأَرْقا )

3 ِمَلَقْلاِب َمَّلَع يِذَّلا )

(

4 ﴾ ْمَلْعَي ْمَل اَم َناَسْنِلإا َمَّلَع )

[

5 -

1 :قلعلا ةروس

]

Dedication

This Thesis is dedicated to My beloved father and mother , My wife Nagat ,and My beautiful kids ,Mohamed, Muaad and Duaa for their patience and sacrifices throughout the completion of this thesis. With love and respect.

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List of Figures

Figure ‎2-1 UK CPI Inflation (1992:1 – 2012:12).Source: BoE Database ... 29

Figure ‎2-2 Monthly BoE official rate (1992:1 – 2012:12) Source: BoE Database ... 30

Figure ‎2-3 inflation, on both the CPI and the RPIX Source David (2013) ... 50

Figure ‎2-4 outcomes of three pointers of economic activity Source David (2013) ... 52

Figure ‎3-1 The Novel-Classical Framework Source: adapted from Palley (2007) ... 59

Figure ‎4-1 Working Finance Capital From (Moore, 1989) ... 95

Figure ‎4-2 Computation of bank advance rate, bank loaning, interest stores and the money related base in the accommodationist model Source: (Palley, (1996) ... 96

Figure ‎4-3 Determination of bank advance rate, demand deposits, bank giving, and the financial base with structuralist attributes From Palley (1996) ... 101

Figure ‎10-1Graphic representation of variables in levels ... 236

Figure ‎10-2 Graphic representation of variables in first difference ... 237

Figure ‎10-3 Graphic representation of variables in levels (in logarithms) ... 238

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List of Tables

Table ‎6-1model-based volatility results Source: Judd and Rudebusch (1998) ... 135

Table ‎6-2 Monetary Policy Rules: Descriptive Statistics Source: John B. Taylor (1999b) ... 140

Table ‎8-1 Alternative estimates of Fed reaction functions Source: Woodford (2003), standard errors in parentheses ... 197

Table ‎8-2 Summary of results on UK reaction function Source: Adam et al. (2005) ... 203

Table ‎9-1 Description of the variables and respective sources Source: Author’s own construct 213 Table ‎10-1 The Augmented Dickey-Fuller (ADF) test results. Criterion by Akaike Information Criterion (AIC) (October 1992 to December 2014) ... 246

Table ‎10-2 The Augmented Dickey-Fuller (ADF) test. Criterion by Schwarz Information Criterion (SIC) (October 1992 to September 2014) ... 247

Table ‎10-3 Phillips-Perron Test (PP) the Bartlett kernel, bandwidth selection automatically using Newey-West (October 1992 to September 2014) ... 250

Table ‎10-4 Kwiatkowski-Phillips-Schmidt-Shin test statistic (KPSS) the Bartlett kernel, bandwidth selection automatically using Newey- West (October 1992 to September 2014) ... 252

Table ‎10-5 Summary Results of Unit Root Tests statistics Sources: The results are calculated by author ... 253

Table ‎10-6 VAR Lag Order Selection Criteria (October 1992 to December 2014) ... 260

Table ‎10-7 cointegration test results (model 2) ... 264

Table ‎10-10 the Pantula Principle for the Taylor Rule, k=1 (October 1992 to December 2014) 265 Table ‎10-11 Cointegration Test Based on Johansen's Maximum Likelihood Method, k=1 (October 1992 to December 2014) ... 266

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Table ‎10-13 Summary Results from the VECM and Diagnostic Tests (October 1992 to December 2014) ... 268

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Chapter 1 Introduction

1.1Introduction

Monetary policy frameworks in most developed countries have seen a dramatic change since 1990s when inflation targeting was first put in place by central banks. Features of the inflation rate during this period increased by almost 25 years to a more steady level than previous monetary policy frameworks. The main parts of a monetary policy include the goal of monetary policy, reaction function, central bank independence, instrument used. After the way out in 1992 of the UK from European Exchange Rate Mechanism (ERM), Bank of England commenced on the newly proposed framework. The growth in liberation of BoE leads to the improvement of the monetary framework. At the onset origination of the novel monetary policy framework which was to modify the inflation target to an policy target an preliminary range of 1% - 4% on RPIX (retail prices index not including mortgage interest payments) but 2.5 percent by the culmination of the Parliament, which was sustained as 2.5% of RPIX in 1997. In the novel measures the Bank’s aim was officially specified as to “uphold stability of price and issue to that impartial, to sustain the economic policy of the government, comprising of its intentions for growth and employment” (BEQB, 1998(2): 93)1

. Inflation targeting, likened to added targets in the UK’s history, has a superior performance in steadying demand shocks and persuading inflation prospects, below a modest examination using the AD-AS model. (See Cobham, 2002). And the publication of inflation forecasts in the Inflation Report, that was extra important characteristic in the novel framework, assisted to liberate the reliability of monetary policy from the low point it got to on Black Wednesday. The

1

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Inflation Report, released initially in 1993, formerly comprised the ‘central projection’ of inflation over the next two years with a range whichever side but this was changed. The 'fan graph' shows a focal gathering meaning the focal figure with 10 percent probability that swelling may fall in this band furthermore exhibits extra gatherings in which expansion would fall with a possibility of 20%, 30%, and so forth. (BEQB, 1996a). The proof kept in this distribution was wanted to enhance the pellucidity and trustworthiness of the financial arrangement, in order to help the private segment comprehend the plans of the national bank better and to lower expansion desires. The character of fiscal approach and the believability of the national bank began to advance especially, the intensified flexibility of the Bank of Britain from 1997 improved that notoriety and set aside a few minutes reliable. Another normal for the new system is that the part of interest rate in impacting the economy was upgraded, or at scarcest clarified. However materials on different parameters including the money related totals is still referred to in the Expansion Report, the strategy creators stress on taking activities on the bank rate. Underneath the across the board New Keynesian model, what influences the premium rate as a consequence of contributing activities, spending and influence total interest. It is the adjustment in premium rate that can influence spending and contributing choices and consequently influences total interest. The Monetary Policy Committee (MPC) in the central bank is committed for variation in interest rate to maintain dependability in cost. The exertion on interest rate decision creation was expressed. The most current information must be gathered and explored before the MPC's month to month gatherings and the data is utilized as a part of the MPC's talk. Every member has his own understandings about the focal expectations on the financial development established on the present examination and various representations (Kohn, 2001).

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When evaluating the economic plan of a central bank, the main problem is in what manner the tool is attuned by the approach creators in light of the improvement of the economy (Svensson, 1999).

The investigation of this inquiry is frequently attempted fundamentally through an examination of the response capacity using Taylor’s rule of the central bank that displays the financial powers' reaction to the deviation of variables from target or pattern.

The interest rate answers to the change of inflation from its board level and to the present output gap, and Taylor anticipated this specific rule with exact coefficients. The interest rates inferred by this decree was relatively comparable to fixed by the Federal Reserve throughout the era 1987-92 (Taylor, 1993).

Most economists assessed a reaction function of that method, so as to acquire guesses of the coefficients for other central banks. Investigations indicate that central banks answering to the monetary growth rate. A specific requirement that have been broadly applied is the ‘forward-looking specification’. The central banks don’t answer to the recent change of inflation from aim, as initially suggested in Taylor (1993), and anticipation of that in the future. In other words, if the policy makers are determining what they must modify with the monthly interest rate, they mostly studied the inflation and output at some future date, for instance the levels expected in one year’s time. For the novel monetary policy framework utilized in the Bank of England since 1992, Taylor rule could be used to compute the reaction function to ascertain variations in Central bank behaviour. Since there are numerous empirical studies which estimate the reaction function of the BoE as, Adam et al (2005), Muscatelli et al. (2002), Nelson (2000), Angeloni and Dedola (1999), Kuttner and Posen (1999) and Clarida et al. (1998) among other.

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1.2Objectives of the Study:

The study aims to shed full light on attempt to investigate the behaviour of the Central Bank of England. In other words, whether Taylor-type policy rules can be used to describe the behaviour of the Central Bank of England. Specifically, we ask to what degree Taylor’s rule (1993) explains central bank policy decision-making; and whether the existence of formal targets has induced nonlinearity in this behaviour, beginning October 1992 until December 2014. This analysis takes the following form:

1- To present an overview of monetary policy in the UK for more than two decades since the UK adopted inflation targeting in 1992. It sought to do this in terms of an analysis of expansionary monetary and fiscal policies and also competition and credit control measures.

2- To develop the theoretical basis of research and, through readings in endogenous money theory, to discover the new consensus in monetary policy and to introduce monetary policy rules as a means of estimating Taylor type reaction functions. In addition, to analyse inflation targeting and instrument independence at the Bank of England.

3- To estimate and test the Taylor rule using the UK and utilising data sampled between October 1992 and December 2014, to determine whether or not the behaviour of the Central Bank of England reflects Taylor-type policy rules.

4- To use original data, to determine the data and research method to be used for this study , This included various different measures of Taylor type policy parameters, we estimate 144 models we check Taylor rule which include different measures of inflation back-looking and forward looking , different measures of output gap. The Output gap is measured by the seasonally adjusted Industrial Production Index. The natural output level

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is the Hodrick-Prescott (HP) trend of the logged. The output gap is then computed as the difference between the logged Industrial Production Index and its HP trend. We also consider a second measure of the output gap constructed as a 3 year backward moving average subtracted by the current unemployment rate. This specification makes its sign consistent with that of the conventional output gap. In addition, the important issue of periodisation or breaking the data into manageable regimes, and the use of descriptions from the academic literature as well as econometric techniques such as structural break analysis. to present an initial econometric analysis , to determine the underlying time series properties of Taylor (1993) type policy rules as applied to the UK.

1.3Significance of the Study:

This study contributes to the body of literature and provides further empirical support that furthers the debate surrounding the validity of the Taylor rule. The Taylor rule is hugely influential in guiding policy decision-making and this study contributes further evidence that combines with other research to assess the actual usefulness of the Taylor. The findings from this study therefore present further evidence for practitioners to consider and question the applicability of the Taylor rule in their context. This generates further insight and understanding about central bank policy making in the UK and provides strong basis to consider the applicability of other principles. Finally, the empirical evidence provided by this study allows us to objectively question the centrality of the Taylor rule leading to further research and understanding of principles to optimise policy and macro-economic performance.

Furthermore, on the empirical level majority of previous studies in the literature are outdated and not up to date, Adam, (2005) and Nelson (2000) amongst others, because

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they have examined the period from 1970 to 2005, therefore there is a nine years gap that needs to be filled. As such, it is important to have up to date studies to assess whether there are any changes have happened. Therefore, the current study examines the period from the 1992 to 2014. In addition, on the practice based policy level, a limited suggests have been provided in previous studies to policy and decision makers. Therefore, this study to fill this gap by providing more recommendations in the light of the study findings.

Furthermore, this study also presents its significance for monetary policy decision makers. In addition, Bank of England and other policy makers can also use the outcomes of this study as an input had they considered using a rule-based policy approach as the basis for monetary policy related decision-making.

1.4Study Methodology

1.4.1The theoretical model:

A monetary policy reaction function describes how a central bank sets its policy instrument in response to the economic circumstances. The Taylor rule as a special reaction function is characterized by the response of the interest rate to inflation and the real output gap. On other words, it has become standard practice to explain the conduct of monetary policy using reaction functions that associate the interest rate with inflation and output. This reaction function the Taylor rule that was first proposed by Taylor (1993) suggests that interest rates are changed according to deviations of inflation from a target and to the output gap. The Taylor (1993) rule takes the following form:

i = r* + pi + β (pi-pi*) + γ(y-y*)

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where i is the targeted nominal Fed Funds rate in percent per year, r* is the targeted real Fed Funds rate in present per year, pi is the rate of inflation over the past four quarters, y is the log of real GDP and y* is the log of potential GDP, thus (y-y*) is the output gap, i.e. the percentage deviation of output from steady state or trend output.

When pi* and r* were set equal to two and β and γ were set equal to half, Taylor (1993) found that equation provided a good description of the behaviour of the Federal Funds Rate over the 1987–1992 period. He also claimed that this rule could be a useful guideline for future monetary policy.

1.4.2Econometric Methodology

The study uses time series estimations of Taylor-type reactions functions to characterise monetary policy conduct in central bank of UK. we use time series data , because all the other studies in this area they are using time series method and recommended it , by Nelson (2003) , Clarida, Gali and Gertler (2000), Adam et al. (2005), and Osterholm (2005), amongst others. In addition, because I have long database this is useful for time series and we didn't use other Method because for this question Taylor rule because we looking long term time series are most appropriate. Furthermore it, a time series data set consists of observations on one or several variables over time. So, time series data are arranged in chronological order and can have different time frequencies, such as biannual, annual, quarterly, monthly, weekly and daily. A key feature of time series data, that makes it more difficult to analyse than cross-sectional data, is the fact that economic observations are commonly dependent across time. By this we mean that most economic time series are closely related to their recent histories. So, while most econometric procedures can be applied with both cross-sectional and time series data sets, in the case of time series there is a need for more things to be done in specifying the appropriate econometric model. Additionally, the fact that economic time series displays

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clear trends over time has led to new econometric techniques that try to address these features, Asteriou and Hall, 2011.

Another important feature is that time-series data that follow certain frequencies might exhibit a strong seasonal pattern. This feature is encountered mainly with weekly, monthly and quarterly time series. Finally, it's important to say that time series data are mainly associated with macroeconomic applications. We analysis uses a modified cointegration and error correction model that is robust to the stationary properties of the data as well as vector autoregression techniques.

Our methodology in this study employed three types of econometric tests namely: unit root tests, cointegration test and error correction models. We used monthly data for the UK over the period 1992-2014, and investigated the evidence for Taylor rule over this period.

As a prerequisite of modern empirical analysis, unit root tests should be applied to the time series whose properties are required to be either static or integrated to a magnitude of one. Specifically, the study will undertake several tests: Augmented Dickey-Fuller (ADF); Kwiatkowski, Phillips, Schmidt, and Shin’s (KPSS); and the Phillips-Perron, (1989).

Cointegration analysis, which has emerged as a recent econometric development, is utilised to examine the long-run relationship equilibrium between integrated time series. Our cointegration analysis using the residual based Engle and Granger approach is evidently very easy to use, also we can use this method since there are only two variables in the system to test the cointegration relationship. But in other situations, if there are more variables, there could potentially be more than one linearly independent cointegration relationship. Thus, it is appropriate instead to examine the issue of

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cointegration within the Johansen framework (Brooks, 2008) (Asteriou and Hall, 2011, Gujarati et al, 2009, Harris and Sollis, 2005).

For short-run analysis the study uses the error correction model (ECM). The estimated error correction model coefficient should be negative and statistically significant in the short-run relationship. With respect to the Granger representation theorem, negative and statistical significant error correction coefficients are necessary conditions for the variables to be cointegrated (Peter. 1998).

1.4.3

1.4.4Data, Variables and Computer Software 1.4.4.1Data

Our dataset consists of monthly frequency observations, starting with October of 1992, when inflation targeting was introduced in the UK, and ending with December 2014, representing a full sample size of 267 monthly observations and they cover 22 years. This period cover a long span of data and, thus, they capture a substantial number of changes in business conditions occurring in our sample. On other words, we employ standard time series that are common in Taylor rule estimation. However, we also make use of a few alternative proxies for the explanatory variables, which are of particular relevance for the UK David (2011), Mihailov (2006), Adam, (2005) and Nelson (2000) amongst others. The purpose of using monthly data observations was to reflect the fact that monetary policy committee decisions are often made on a monthly basis though sometimes there is no change. For the rate of inflation, the retail price prices index was adopted and modified to excluding mortgage interest payments when they became available. The aim here is being to map the initial inflation target measure under the regime of instrument independence.

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All-time series were downloaded from the statistical pages on the websites as following (i) UK Office of National Statistics (ONS) obtain from it on inflation rate, consumer price index (CPI) Inflation , target rate of inflation ,output (Calculated from claimant count rate . unemployment) and index of industrial production. (ii) The Bank of England (BoE) obtains from it on bank rate and Treasury bill rate.

1.4.4.2 Variables:

1- Nominal short-term interest rate:

Nominal short-term interest rate in his original study, Taylor has used the federal funds rate, which was later replicated as the natural choice for the U.S. In other papers, which include different samples, the short-term interest rate is represented by an interbank lending rate for overnight loans, or a 3-month Treasury bill. Therefore, in our Taylor rule estimation we employ standard time series that are common in similar studies. However, we also make use of a few alternative proxies for the explanatory variables, which are of particular relevance for the UK which are of particular relevance for the UK, David (2011), Mihailov (2006), Adam, (2005) and Nelson (2000) amongst others. In this study we will use tow variables to measure Nominal short-term interest rate:

i- The official bank rate.

ii- The three - month Treasury bill rate.

2- Inflation

Inflation data in our study by two alternative indices that are usual choices when working with UK data:

i- The Consumer price index Inflation (CPI), as for this variable, which is the standard measure of inflation in most other economies, including for the purposes of monetary policy, and it has become the

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official index accounting for the evolution of the UK general price level, as in Creel et el (2013), Mihailov (2006), Kesriyeli et al. (2004) and Martin and Milas (2004) among others.

ii- Inflation Rate (RPIX) as, for instance, in Mihailov (2006) and Nelson (2003).

(You can see data transformations in Appendix three. Backward-Looking and Forward-Looking).

3- Output Gap

The most difficult variable to quantify is the output gap. It is also the most vulnerable for criticism for there is a variety of ways, in which it can be calculated, therefore, the output gap is usually defined as the deviation of actual output from potential output. Traditionally, potential output is measured by an estimated trend. The output gap is thus the deviation of output from its trend.

However, a variety of output gap measures are presented in the academic literature, though without firm consensus on any particular one. In our study by two alternative measures of the output gap indices, this is according to academic literature. In our study we use two variables to estimate output gap as following:

1- Industrial Production Index:

We estimate output gap by the seasonally adjusted Industrial Production Index, by use the Hodrick-Prescott (HP) filter (with a smoothing parameter of 14,400, recommended for monthly data) since it is the most commonly accepted way of measuring potential output. In addition, we have focused on the Index of Industrial Production rather than GDP for

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several reasons. First, being published monthly, there is more data available for Industrial Production than for gross domestic product. Second, the Industrial Production series is timelier than GDP and is therefore watched more closely by business, financial, and economic professionals for making business, trading, or policy decisions. Third, the Industrial Production series is more interesting and challenging from a time series forecasting standpoint than is GDP Moody et el (1993) and Joachim et el (1995). Fourthly, because the variability of Industrial Production is higher than the variability of GDP, Philip Arestis, et el (2002). On the other hand, the index of industrial production is used since it closely approximates GDP and also reflects the frequency of monetary policy committee decisions. The series is smoothed using a Hodrick-Prescott (1997) filter from the literature on real business cycle theory thereby making the trend more sensitive to long term rather than short term fluctuations. This adjustment is achieved by subtracting the solution to equation (1.10) in (Appendix three) from the original industrial production series.

2- Output (Calculated from Claimant Count Rate i.e. Unemployment)

We also consider a second measure of the output gap constructed from unemployment (Seasonally adjusted UK persons monthly claimant count rate), due to unemployment enters the data set in the form of the claimant count rate as a possible factor in decision making, and also because of the role of the non-accelerating inflation rate of unemployment (NAIRU), though minor issues concern the reliability of this variable; unemployment figures are not subject to final revision whereas output figures are. Seasonally adjusted observations are however, available from the beginning of the sample period, though it is acknowledged that this is a narrow measure and does not correspond to the current National Statistics definition of unemployment. Equation (1.9) in (Appendix three) illustrates a second alternative, which is a relative claimant count rate measure. This is calculated by the difference between current period observations and a

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thirty-six month average. The rate of unemployment has fluctuated substantially over the entire sample period and a horizon of thirty six months compared to say, twelve months, is preferred to allow for a more meaningful understanding of the data. In this regard, Hyeongwoo et el (2014),Ben et el (2003) and Kuttner (1994) provide a useful survey of existing measures of output gap , therefore, The output gap estimate as a 3 year backward moving average from the current unemployment rate. This specification makes its sign consistent with that of the conventional output gap, Kim (2014), Boivin (2005). However, to overcome this it was also noted that an alternative relative claimant count measure might be used which was calculated by taking the difference between current period and thirty-six month moving-average period observations.

1.4.5The Hodrick Prescott (HP) filter:

The Hodrick and Prescott (1997, 1980) filter (hereafter, the HP filter) has become a standard method for removing trend movements in the business cycle literature. The filter has been applied both to actual data (Fiorito et .al , (1994) ,Danthine et .al (1993) ,Backus and Kehoe, (1992), Blackburn et . al (1992), Brandner et . al (1992), Kydland and Prescott, (1990) and Danthine et . al (1989) and in studies in which artificial data from a model are compared with the actual data (Backus, Kehoe, and Kydland, 1992; Cooley and Hansen, 1989; Hansen, 1985; Kydland and Prescott, 1982).

However, the Hodrick Prescott filter has been used to separate the cyclical component of some time series such as coincident business cycle and industrial production from their potential levels. Hodrick and Prescott (1997) consider that a series (y) is composed of a trend (s) and cyclical component (c). As such, the Hodrick-Prescott (HP) filter is a filter that computes the smoothed component (s) by minimizing the variance of (y) around (s), subject to a penalty that constrains the second difference of (s). The illustration is given by:

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∑𝑇_𝑡−1(𝑦_𝑡− 𝑆_𝑡) 2

+ λ ∑𝑇_𝑡−2((𝑆_𝑡+ 1 − 𝑆_𝑡) - (st – st-1)) 2

Where (T) is the number of observations and (λ) is the penalty parameter. The value of (λ) depends on the frequency of the data and the larger the value if (λ), the higher is the penalty. The value of lambda used in the procedure was 14400, which is the recommended value for monthly data. The advantage of the HP filter is that it renders the output gap stationary over a wide range of smoothing values and it allows the trend to change over time. Another advantage is that it does not need any additional variables to construct potential output.

1.4.6Periodisation

Periodic accounts of monetary policy development in the UK are presented by David (2011), Adam et al. (2005), Nelson (2000) and Cobham (2002) amongst others. British monetary policy has evolved substantially in the past quarter-century. Policymakers have moved through three distinct monetary regimes: broad money targets in the late 1970s and early 1980s, exchange-rate targets in the late 1980s and inflation targets since the early 1990s. Each of these broad periods was conducted with varying levels of commitment by the monetary authorities to their targets, and within each regime there were frequent changes to the nominal target and stance of monetary policy. In this study we will focus from October 1992 when the inflation targeting was introduced in the UK. Although, a firm consensus on the exact dating of policy regimes does not exist in the academic literature and studies such as Cobham et al. (2001) for example, identify sub-periods on the basis of an examination of how policy evolved. The two studies cited at the beginning of this paragraph also examine the development of monetary policy, reaching broadly similar conclusions in their determination of sub-periods. It might be noted that such examinations are comprehensive in their coverage and can be referred to rather than repeated here. The general approach identifying sub-periods might further be

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considered indicative of the Taylor rule as a description of monetary policy, and with this in mind, the following sub-periods be identified for the UK. With such an erratic history, it is of interest whether the effectiveness of British monetary policy has changed in a significant way. Taylor (1993) introduced a positive metric for determining the goals of monetary policymakers, expressed in simple interest-rate reaction functions as well as normative rules for judging the effectiveness of policy, particularly through an analysis of the magnitude of the coefficients on the reaction function. Since then, the literature on Taylor Rules has expanded considerably and various authors have estimated Taylor-type reaction functions for a wide cross-section of countries. Prior approaches to estimating Taylor Rules, whether in the UK or more generally, either tend to estimate a single rule for long time periods, or exploit the narrative history to identify changes in announced central bank policy and estimate separately for each period. The first approach ignores the possibility of structural breaks in the monetary policy reaction function and risks biased coefficients on the parameters of interest. The second approach offers an improvement by acknowledging the possibility of structural change in the reaction function, but implicitly assumes that the change in actual policymaking occurs at the moment of the announcement of a change in policy. However, it is plausible that these two events may occur with a lag: an announced change in policy may reflect a change in de facto policymaking some quarters prior, or an announced change in policy may only be implemented with a These possibilities pose serious challenges to the determining the timing of breaks in sub-periods. For estimations purposes then, sub-periods for estimation might follows as Nelson (2002), Adams et al (2005) and David (2011):

1- October 1992 to December 2014: the full sample period.

2- October 1992 to April 1997: the exit from the Exchange Rate Mechanism (ERM) ,beginning inflation targeting in the UK ,and prior to the Bank of England receiving operational independence.

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3- May 1997 to September 2014: the characterises the current UK monetary framework namely inflation targeting with Bank of England of operational independence.

The estimation was calculated by using EViews 7,( computer software).

1.5The Research Problem

Over more than two decades simple monetary policy principles have attracted increasing attention for the purpose of analysing the central bank monetary decision-making , Orphanides, A. 2003. The underlying motivation of this interest lies in economic insights that can be summarised by applying simple rules in relation to familiar variables such as the policy rate level ,Kahn, 2012. Monetary policy rules approaches provide the basis for exploring the relationship between monetary policy decisions and the departure of policy objectives from trend or target. In the literature this debate on simple policy rules has centred on Banks’ evaluation of monetary conditions (Stuart, 1996; Hauser and Brigden, 2002).

Within the field of modern macroeconomics there is significant consensus that policy rules hold greater merit over a discretionary approach for maximising economic performance (Taylor (1993). Several authors provide robust critique of discretionary policies due to time inconsistencies (Kydland and Prescott, 1977; Barro and Gordon, 1983). For instance, in the case of low inflationary policy the discretionary powers available to monetary authorities provide significant scope for dynamic inconsistencies against the rational expectations of economic agents. Punitive action by private agents against policy decision-makers for not complying with announced rule and reputational issues could mitigate the time inconsistency issue (Barro and Gordon, 1983a). Additional measures to the time inconsistency problem have been proposed; Rogoff (1985) proposed delegating powers to conservative and inflation-averse policy makers, while Walsh

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(1995) advocated the inclusion of a punishment criterion into contracts of key decision-makers at the central bank.

Whereas all this research confirms that rules are superior to discretion, it fails to provide or prescribe specific practical implications for policy making. To address this Taylor proposed a practical and simple rule that advocated setting the short interest rate in line with prevailing economic conditions (Taylor 1993). Taylor made a condition that equal importance is attached to interest rate and inflation rate variables in the reaction function. This is viewed as essential to enable decision-makers to mitigate time inconsistency and formulate optimised policies consistent with the macroeconomic environment. Barro and Gordon (1983a) emphasise the technical feasibility of this principle on the grounds that it is easily verified externally.

Over recent years, central bank policy behaviour has become an increasingly significant area of interest focused on the extent to which Taylor’s rule can sufficiently explain central bank behaviour. Some empirical evidence (Clarida et al., 1999; Rudebusch and Svensson, 1999; Sack and Wieland, 2000) indicate a cautious interest rate policy that is explained by the Taylor rule. A further question of interest relates to whether the econometric models are capable of replicating central bank decision-making. In examining central bank behaviour several studies (Blinder, 1999; Goodhart, 1999; Johnson and Siklos, 1996) found that decision-making did not simply reflect responses to economic conditions ,Rudebusch and Svensson, 1999.

Assessment and forecasting of economic factors consist of a broad range of tools including common simple rules, and monetary policy instruments that inform bank monetary strategy and policy-making,HM treasury .2013. Different models are generated to forecasts and inform policy. Measures prescribed for policy-making are subject to

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depth analysis to establish an accurate and robust evaluation of the policy position and the potential of future inflationary pressure.

The crucial questions in this study are:

 Does the Taylor rule work?

 Does the Taylor rule sufficiently explain monetary policy in the UK during the inflation-targeting regime 1992−2014?

 Does the Taylor rule significantly account for central bank policies? These questions will be examined in this study.

The aim is to estimate Taylor-based policy rules for the UK to address the research questions.

1.6The Structure of the Study

Chapter two begins with an overview of monetary policy in the UK between 1992 and 2014. Monetary policy at the Bank of England, Constitutional framework, main priorities, monetary policy and the current state of inflation and The Institutional dimension of BoE monetary policy. Then moves on to a look taken by the new government in 1997 to shift control of interest rates from the Chancellor of the Exchequer (minister of finance) to a new Monetary Policy Committee (MPC) at the Bank of England (BoE).

Chapter three presents an overview of the currently competing theories of monetary policy, an exposition of the key assumptions and equations of the New Consensus Macroeconomics (NCM), as well as the implications and limitations of the NCM. The link between the NCM and inflation targeting (IT) is discussed.

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Chapter four present theoretical background of the endogenous money theory, discusses the endogenous money approach, discusses Money Supply Creation: Post-Keynesian Theory, and the basic elements of a theory of endogenous money.

Chapter five presents the operation of monetary policy in terms of a framework where credit money is endogenously created by the banking system. This chapter covers the new consensus as illustrated by Meyer (2001) as well as a look at transmission channels of monetary policy. This is followed by another section on monetary policy and aggregate demand where we make reference to authors such as Arestis and Sawyer (2003). A further section considers the role of monetary policy and the exchange rate followed by, a development of the endogenous money framework from a Keynesian perspective. Monetary policy in an endogenous money framework considers liquidity preference. The exchange rate, the role of fiscal policy and also the objectives of monetary policy. The analysis also includes coverage of fine tuning with monetary policy and monetary policy instruments before rounding up with a conclusion of material discussed.

In chapter six, we introduce monetary policy rules as a prelude to forthcoming chapters which will seek to estimate Taylor type monetary policy reaction functions. These include a look at some of the preliminary modeling issues such as types of variables to be used in a potential Taylor rule together with some of the issues. They monetary policy rule of Taylor and others is also presented in this chapter. The second part of this chapter on monetary policy rules considers optimal monetary policy rules and how these might be used in practice and also their relevance to monetary policy transmission. The chapter also offers a consideration of trade-offs and shocks from demand and supply, rule specifications and proposed parameters, the role of the exchange rate and also addresses the issues of stability and the output gap. The chapter concludes with a summary of key, issues discussed.

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Chapter seven introduces the definition of inflation targeting, prerequisites for inflation targeting and advantages and Disadvantages of using Inflation Targeting. Introduces inflation targeting and considers the role of inflation targeting in a new consensus framework. Some of the theoretical aspects of inflation targeting are also considered including the nominal anchor, real and monetary factors, the causes of inflation and also inflation and the monetary policy transmission mechanism. The chapter then introduces some empirical evidence on inflation targeting including inflation targeting and macro-econometric modeling and inflation targeting in the context of single equation techniques before rounding off with a conclusion on key insights.

Chapter eight presents the review of the empirical literature that have tested Taylor rule. Most of these studies have been applied to developed and industrial countries.

Chapter nine presents the methodology adopted for this study. It considers some of the variables to be used for the purposes of estimating Taylor type monetary, policy rules. It also considers the important issue of periodisation or how to break the data into manageable regimes. This has been a key issue since there is some debate over how to determine the appropriate time periods. Generally there are two approaches to this; one is using descriptions from the academic literature and the second is to use econometric techniques such as structural break analysis. This section also makes reference to the actual appendix used for this study containing some of the data estimates.

Chapter ten we present the results of an initial econometric analysis and this consists of tests for the order of integration, which include common unit root approaches. The results from unit root tests are used to determine how the data should be modeled and whether or not cointegration analysis should be conducted. This chapter also considers the determination of appropriate lag lengths for cointegration testing, the use of deterministic trends for model selection or in other words the Pantula (1989) principle, the Johansen

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approach to cointegration testing and also further statistical tests such as weak exogeneity, linear restrictions and parameter stability.

Chapter eleven discusses the results of this preceding chapter in terms of implications for monetary policy.

Chapter twelve concludes this thesis by highlighting the main results and presenting academic contributions, implications and limitations.

1.7Conclusion

This introductory chapter sets out the background and the objectives of the present study together with a brief explanation of the organization of this thesis. The next chapters will further develop this work and come into more rigorous analyses and work on achieving the objectives of the study.

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Chapter 2

UK Monetary Policy since 1992

2.1Introduction

The role of central banks as guardians of monetary and financial stability has increased over the years, in both the UK and other countries and inflation targeting monetary policy has become the overriding mechanism through which decision makers endeavour to promote stability and economic growth. Arguably, policy decisions made by central banks may have a rather considerable bearing on both the state and the outcome of real economic activity. Developments in monetary policy are reflected not only by changes interest rate but also by variations in the amount of money in circulation. On one hand, affecting short-term interest rates seems to be the most common way in which monetary authorities aim to control inflationary pressures and support economic development. On the other hand, particularly in periods characterised both by low interest rates and low levels of growth, central bankers usually employ quantitative easing as the basic tool for economic recovery. The recent global economic downturn that began in 2007 and its broad effects on various aspects of economic activity have rendered rises in money supply and market liquidity necessary for economic recovery. However, this chapter considers the main frameworks of monetary policy adopted in the UK since 1992. For twenty-two years, monetary policy in the United Kingdom (UK) has been functioning in an administration of inflation targeting (IT), from which the last seventeen years and a half likewise below functional freedom of the central bank. However, the UK fiscal powers moved to swelling (conjecture) focusing on in October 1992, and in May 1997 the Bank of Britain (BoE) was formally allowed operational freedom from Her Greatness' (HM) Treasury.

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2.2Monetary policy at the Bank of England

2.2.1Constitutional framework, main priorities

The Bank of England (BoE) was recognized in 1694 and is the second oldest Central Bank in the world (with the Central Bank of Sweden; namely, Sveriges Riksbank being the oldest one, as it was established in 1668). Initially, BoE was privately owned, serving as the Government’s banker, but in 1946 the bank was nationalised and its capital stock was transferred to HM Treasury (BoE, 1946). According to King (2012), the first step toward an independent BoE was taken in February 1993 when the Bank released its first Inflation Report, while in 1997, BoE assumed the overall statutory responsibility for setting the nation’s interest rate; a development that gained the Bank absolute instrument independence. This independence was marked by the establishment of the Monetary Policy Committee (MPC) (BoE, 1998).

In recent years, BoE’s key responsibilities, apart from acting as a banker for HM Government, further include the management of the country’s gold reserves and the management of the country’s foreign currency assets and liabilities (BoE, 2012c). On the other hand, the bank is no longer involved in the monitoring of the banking system and the management of national debt while the responsibility for both of these tasks has been passed on to the Financial Services Authority (FSA) and the Debt Management Office (DMO) respectively (Mishkin, 2013). Also accountable for supervising the affairs of the Bank and setting its core purposes and strategic priorities is the Court of Directors. The latter has explicitly defined the core purposes of the Bank as the assurance of monetary stability (e.g. by bolstering confidence in the currency and targeting price stability) and the contribution towards the achievement of financial stability (e.g. by an efficient oversight of the financial system in general) (BoE, 2012c). The Court of Directors reviews its strategy on a quarterly basis (BoE, 2012c). Therefore according to Mishkin (2013), neither price nor output stability is sufficient to ensure financial stability. In fact,

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the period of the Great Moderation; that is, the period that began in the early 1980s and ended with the global financial crisis that began in 2007 - and in which, central banks had managed to control inflation and to decrease the volatility of business cycle fluctuations (Taylor, 2009; Mishkin, 2013) - can be thought of as a period in which market participants were willing to take on excessive risks, predicated on the false assumption that only a small amount of risk was present in the economic system (Mishkin, 2013; Bean, 2010). In this regard, price stability might even have assisted with the fabrication of the global financial disaster.

An exhaustive list in connection with the bank's main current strategic priorities (as described in BoE, 2012c) entails the following:

Core Purpose I: Monetary stability

 Keep CPI inflation on track to meet the Government's 2% target: This relates to the commitment by the MPC to set monetary policy instruments in order to realise the goal set by HM Government, or to bring inflation back to target (i.e. within a reasonable period of time) at times when due to economic shocks or other disturbances it deviates from the adopted level of 2% (BoE, 2013; BoE, 2012c). In so doing, the MPC should consider the impact on the economy of unconventional tools of monetary policy, account for the interaction between monetary and macro prudential policy, (BoE, 2009), as well as, exploit all available econometric models to facilitate forecasting and policy analysis (BoE, 2012c).

 Guarantee the Bank has the strategies, devices and foundation set up to actualize fiscal strategy and provide banknotes: This strategic priority entails that the bank is prepared to support its adopted strategy in the face of disbelief or inflated expectations on behalf of economic agents - mainly concerning what monetary

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policy can or cannot do - largely generated from the current adverse economic conditions (BoE, 2013; BoE, 2012c). It also implies that the bank will consider potential risks related to a number of issues such as appropriate staffing, appropriate modelling, as well as, reputational consequences in the event of unanticipated outcomes (BoE, 2012c).

Core Purpose II: Financial stability

 Maintain stability and develop the resilience of the financial system: In February 2011 the Court of Directors of BoE created an interim Financial Policy Committee (FPC) charged with identifying potential sources of disturbance to the financial system (see BoE, 2012d). The FPC is also responsible for reducing the systemic risk by implementing the appropriate policy tools (BoE, 2012c; BoE, 2012d; Clark, 2012). In this spirit, BoE has to contribute not only to the international discussion on resolutions that promote financial stability, but also, to the development of both pre-emptive and recovery financial plans.

 Deliver macroprudential policy, operating through the FPC: This strategic priority mainly involves the coordination among the FPC, the Financial Services Authority (FSA) and HM Treasury towards the formulation of an international framework of macro prudential regulation (BoE, 2012d; Clark, 2012).

 Complete the change of micro prudential supervision and infrastructure omission: In short, this priority entails close cooperation among the FPC, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) in an effort to protect the stability of the financial scheme from the aggregate behaviour of firms (HM Treasury, 2012)

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Supporting Core Purposes:

 Build and bear public sustenance for the Bank’s governance and for its monetary policy, macro and micro prudential frameworks: The bank should take every necessary measure to ensure clarity and transparency in all of its operations and decisions (BoE, 2012c; BoE, 2012d).

 Certify the Bank has the right people and procedures to convey out its main resolutions - in specific during this age of transition: Within the framework of a longer-term business plan within the bank, emphasis should be put upon improving the efficiency of all resources that are put to work.

The price stability (inflation) target is specified (at least once every year) by the Government and then MPC is charged with achieving the target (BoE, 2013; BoE, 2012c). The MPC assembles at least once every month and its decisions become publicly available usually two weeks later (BoE, 2012c; Goodhart, 2000). Furthermore, as is usually the case in most inflation targeting central banks, BoE publishes on a quarterly basis a report on inflation which comprises quarterly projections regarding the level of inflation and output, as well as, lengthy studies of the factors that are likely to affect inflation in the future. Informing the public on a regular basis of the potential inflationary paths is highly important especially when it comes to managing expectations regarding the future level of inflation (BoE, 2013, BoE, 2012c, Sims, 2007, and Wallis, 2004).

Turning to econometric modeling at BoE, that all types of available models are employed in order to assist monetary policy decision making (Garratt et al, 2012, and Pagan, 2003). The basic model employed by BoE for the production of monthly projections regarding the future course of UK banks’ profits, as well as, for performing stress-tests is the Risk Assessment Model of Systemic Institutions (RAMSI) which is basically a large-scale