Inflation Targeting in the UK: Stochastic Simulations of a Forward-Looking Macroeconomic Model

Andrew Blake and Peter Westaway
National Institute of Economic and Social Research, London
PWestaway@niesr.ac.uk

Abstract

It has become increasingly common for macroeconomic policymakers to adopt an explicit target for the rate of inflation. But, given the uncertainty surrounding the likely behaviour of the economy and the expected size of unanticipated shocks which might buffet the economic environment, how successful can policymakers hope to be in achieving their pre-announced target range for inflation? This paper analyses this issue by conducting a comprehensive stochastic simulations analysis of inflation targeting using the NIESR macroeconomic model of the UK economy. The model chosen is particularly appropriate for this exercise, not only because it is a large empirically based non-linear model with theoretically well-defined equilibrium properties, but also because it embodies forward-looking behaviour in the equations for foreign exchange, bond and equity markets, wage and price setting, and investment and consumption decisions. A stochastic simulation exercise on this type of model allows a realistic test of different policy regimes. Moreover, by taking into account the effects of unexpected disturbances, it is possible to address the question of the appropriate design of the `band-width' for the inflation target. The paper illustrates the sensitivity of the expected variance in inflation to the specification of the policy regime, indicating the extent to which certain indicator variables might serve as early warning signals of future inflation and hence may help to reduce the expected variance. By conducting the exercise on a forward-looking rational expectations model, it is also shown how the effectiveness of any particular policy regime will be affected by the extent to which it is believed and understood.