S.G.B. Henry 941model shown in Figure 18.3 is broadly consistent with the events of the first half
of the 1980s, and suggests that this can be seen as a high inflation outturn due to
the authorities’ mistaken belief about the natural rate, but revisions to the other
parameters in the authorities Phillips curve lead to tighter monetary policy and
inflation then falls to a relatively low rate after about three to four years.^34
However, inflation rose markedly again at the end of the 1980s decade. The
argument advanced here is that this further bout of higher inflation was due to
yet another mistake by the authorities, this time about the probable trend rate of
growth of productive potential in the economy. This mistaken assumption was in
keeping with their view that a lower natural rate was to be expected following the
“supply side” changes introduced by the government in the first part of the 1980s.
The assessment of the evidence summarized in section 18.4 is that these alleged
effects from the supply side did not happen. But official estimates of whole econ-
omy output per head show that in the period 1985–88 this was estimated to be at a
rate of 3.25%, up from the 2% rate of growth for the period 1979–87 (FSBR, 1988,
p. 30).^35 Due to this mistaken belief in a faster non-inflationary rate of growth,
the Treasury appears to have significantly underpredicted inflation in 1989–90.
Barrell, Khoman and Kirby (2007) report that the (retail price index) inflation fore-
casts made by the Treasury for 1988, 1989 and 1990 were, respectively, 4.5 (6.5),
5.5 (7.6) and 7.25 (10) (inflation outturns in brackets), each of which is evidence of
a consistent and marked optimism about inflation. In later FSBR reports, in the face
of a slowdown in the rate of output per head, the Treasury placed less emphasis on
this trend improvement view. In other words, its belief in an improved productiv-
ity performance appears to have been short-lived. We argued above that this case
is similar in its effects to the case shown in Figure 18.5, where the authorities are
not aware that adverse external shocks on the economy have increased the natu-
ral rate and, as result of this mistake, inflation increases. The belief that potential
growth is higher than it actually is would have a similar effect. But it is important to
note that the solution shown in Figure 18.5 allows for permanent ignorance of the
authorities about the effects of external shocks and inflation shoots up as a result.
In reality this is too extreme. Thus, to relate this to the parallel case of a mistaken
belief in an underlying productivity improvement in the late 1980s in the UK, it
needs to be recognized that this belief soon evaporated. Even so, this temporary
belief would have produced a spurt in inflation in line with what happened.^36
18.6 Conclusions and proposals for future work
Evidently, both the empirical and the more theoretical material described in this
chapter are limited. Thus, although we have sought to extend the policy model
to allow for external (international) effects, in practice these are restricted to hav-
ing effects only on the evolution of the natural rate. More direct transmissions of
international changes in real commodity prices or international structural changes
(“globalization”) onto UK import price or consumer price inflation, for example,
have been ignored and extensions to include some of these developments is an