There is widespread agreement that the changes in UK monetary policy introduced in 1997,
with interest rates set by the Bank of England’s Monetary Policy Committee (MPC), were
desirable and successful.
But those changes occurred in the wake of a sharp appreciation of the pound sterling,
which most commentators regard as having made sterling seriously overvalued. And that
overvaluation appears, surprisingly, to have continued undiminished ever since, despite the
pressures it has placed on the UK’s traded goods sector.
A series of papers in the June 2006 issue of the Economic Journal looks again at such
‘open economy’ issues and the way they are handled within the UK’s monetary framework.
Overall, the papers argue that the open economy element of the monetary framework
needs to be rethought.
In the first paper, Professor David Cobham discusses how monetary policy-makers have
perceived the movements of the exchange rate. He shows that they have had great
difficulty both in forecasting the future course of sterling and in explaining its past
movements. And he examines how the MPC has debated various responses to the change
and level of sterling but in the end never made any decisive moves to correct it.
One reason was that MPC members believed that the exchange rate was erratic. But in
that case, as Cobham points out, there is a case for a reconsideration of the monetary
framework, including the case for adopting the euro.
In the second paper, Professor Simon Wren-Lewis and colleagues examine whether
optimal monetary policy should be different in an open economy from in a closed economy.
They develop a ‘new open economy macroeconomic’ model, which includes ‘international
risk-sharing shocks’ (which affect the exchange rate).
These researchers show that within this model, the optimal policy should target domestic
output price inflation rather than overall consumer price inflation (which includes imports).
More importantly, they show that optimal policy should respond to what they call the ‘terms
of trade gap’, which is close to the deviation of the real exchange rate from its underlying
equilibrium.
In the last paper, former MPC member Christopher Allsopp and colleagues focus on the
empirical pass-through from exchange rates to prices. They argue that the observable data
can be explained only in terms of a concept of imports as intermediate inputs into
(domestic) output. If that is so, then policy-makers should indeed target consumer price
inflation (as the MPC does).
This analysis has implications for standard estimates of ‘domestically-generated
inflation’ (which is typically calculated by making an assumption about the pass-through
and then subtracting the imports-cum-exchange rate effect from overall inflation), and for
the way policy has been conducted in recent years.
But it also means we need to rethink the effect of an exchange rate change on the
economy, since in this case such a change affects potential domestic supply of goods and
services as well as domestic and external demand.
Overall, these papers strongly suggest that the open economy element in the current
monetary framework is unsatisfactory, and that we need more research – on the modelling
of trade relationships, on the determination of exchange rates and on the appropriate policy
responses to external shocks of different kinds.
ENDS
Notes for editors: ‘Monetary Policy and the Sterling Exchange Rate’, a series of papers
edited by David Cobham, is published in the June 2006 issue of the Economic Journal.
The three papers are ‘The Overvaluation of Sterling since 1996: How the Policy Makers
Responded and Why’ by David Cobham; ‘Should Central Banks Target Consumer Prices or
the Exchange Rate?’ by Tatiana Kirsanova, Campbell Leith and Simon Wren-Lewis; and
‘UK Inflation Targeting and the Exchange Rate’ by Christopher Allsopp, Amit Kara and
Edward Nelson.
David Cobham is Professor of Economics in the School of Management and Languages at
Heriot-Watt University, Edinburgh EH14 4AS
(http://www.sml.hw.ac.uk/Staff_Profiles/DavidCobham.html).
For further information: contact David Cobham on 0131-451-3495 (home: 01334-475092;
email: d.cobham@hw.ac.uk); or Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).