18

Monetary Policy, Beliefs,

Unemployment and Inflation: Evidence

from the UK

S.G.B. Henry

Abstract

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

18.1 Introduction: inflation and unemployment in the UK 918
18.2 A selection of background literature 920
18.2.1 A baseline New Keynesian policy model 920
18.2.2 Evidence for and against monetary regime change in the US 921
18.2.3 The importance of uncertainty 923
18.2.4 The effects of openness 924
18.3 Beliefs and monetary policy 924
18.3.1 Motivation 924
18.3.2 A basic learning model of monetary policy 925
18.4 Long-run unemployment: evidence from wage and price equations 927
18.4.1 Behavioral models of the labor market 927
18.4.2 An empirical assessment of the wage and price push variables 929

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