Palgrave Handbook of Econometrics: Applied Econometrics

940 Monetary Policy, Beliefs, Unemployment and Inflation

1.2

1.7

2.2

2.7

3.2

3.7

4.2

1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 101

Period

Percent

Figure 18.5 The second solution for inflation

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

(a) (b)

1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96101

Period

–0.9

–0.8

–0.7

–0.6

–0.5

–0.4

–0.3

–0.2

–0.1

0

1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96101

Period

Figure 18.6 (a)γ 0 t, (b)γ 1 t

since the 1980s. Thus, starting at the beginning of the 1980s, UK output, unem-
ployment and inflation were dramatically worsened by the 1979 oil price shock,
but the effects of this were compounded by a significant switch in the 1980 bud-
get to lower direct tax rates, aiming to offset this with increases in excise tax,
petroleum revenue tax and increases in value added tax (VAT). The policy philos-
ophy for control of inflation at this time was governed by the MTFS which was,
in turn, predicated on targets for a wide monetary aggregate (£M3) and the (mis-
taken) belief in a predicable relation between changes in the monetary aggregate
and inflation. The interpretation of these events offered here is that, because of
its adherence to the MTFS, particularly its assumption that the natural rate was
a given, the government expected the effect of the external shock to oil prices
on unemployment to be smaller and shorter-lived than it was. In the event, it
was not until 1986 that unemployment began to fall significantly. Inflation fell
more quickly, and by 1983 was down to about 4%. The numerical solution of the