Dynamic effects of monetary policy shocks on macroeconomic volatility in the United Kingdom

ABSTRACT

We use constant and time-varying parameters vector autoregressive models that allow the estimation of the impact of monetary policy shocks on volatility of macroeconomic variables in the United Kingdom. Estimates suggest that an increase in the policy rate by 1% is associated with a rise in unemployment and inflation volatility of about 10% on average, with peaks observed during episodes of local and global crises.

KEYWORDS:

• Non-linear SVAR
• stochastic volatility
• monetary policy shock
• United Kingdom

JEL CLASSIFICATION:

• C32
• E30
• E40
• E52

Acknowledgments

We would like to thank an anonymous referee for many helpful comments. However, any remaining errors are solely ours.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The SSR is available for download from: https://sites.google.com/view/jingcynthiawu/shadow-rates?authuser=0

² Besides sign restrictions, studies have also used large-scale factors-augmented VARs or Bayesian VARs (see, for example, Bernanke, Boivin, and Eliasz (2005), Bańbura, Giannone, and Reichlin (2010)) to solve the theoretically inconsistent results of the output and price puzzles following a monetary policy shock often observed in small-scale monetary VARs (Walsh 2017). Note that, price and output puzzles relate to situations where both output and price level (or inflation rate) tend to increase initially, rather than decreasing immediately, following a contractionary monetary policy shock.

³ Based on the suggestion of an anonymous referee, we repeated our analysis by replacing the unemployment rate, with the year-on-year growth rate of the industrial production index (IPI), derived from the MEI database of the OECD over the period of 1961m1 to 2019m10. We found that our basic conclusion, complete details of which are available upon request from the authors, in terms of the contractionary monetary policy enhancing macroeconomic uncertainty continues to hold. Note that, we do not present these results explicitly in the paper to save space, and also because the explanation of the empirical results rely on a theoretical model of search and labour market frictions associated with unemployment and not industrial production, and hence ensures consistency across the theory and empirics.

⁴ Based on the suggestion of an anonymous referee, we also identified the monetary policy shock based on a recursive (Cholesky) decomposition scheme, with the variables ordered as unemployment rate, inflation, policy rate, and the term-spread. The results from the recursive identification is presented in Figure A1 in the Appendix of the paper, and indicates that our basic results are qualitatively similar, but we do observe the existence of the ‘price puzzle’, which in turn provides the empirical motivation for the sign-restriction approach in our context.