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A little bit more evidence on the natural rate hypothesis from the U.K.
E:luropean Economic Review 25 (1984) 279-292. North-Holland
A LITTLE BIT MORE EVIDENCE ON THE NA AL RATE HYPOTHESIS FR0M THE UK. Charles IQ. BEAN* London School of Economic s, London WCZA 2AE, UK
Received February 1984, final version received July 1984 The evidence for the neutrality of anticipated changes in moaetary policy in the U.K. over the period 1963Ql--198241 is examined. Breaks in the stochastic process generating the money stock arc used to identify the model. The results, are generally unfavourable to the proposition that onl!s unanticipated money matters.
1. Introduction One of the most important propositions advanced in macroeconomics in the last decade concerns the impossibil.ity of systematic activist monetary policy. In an economy where the natural rate of output is independent of the rate of monetary growth, there are no rigidities and expectations are rational in the sense of ~Muth (1961) then anticipated changes in aggregate demand arising from attempts by the authorities to pursue a countercyclical monetary policy will already have been taken into account by agents when making their expenditure and output decisions and will therefore lead to no further response in activity. This neutrality proposition, associated especially with Lucas (1973), and Sargent and Wallace (1975), has prompted a number of authors to construct models with rational expectations in which there is nevertheless a role for a feedback monetary policy on account of informational asymmetries, supply-side rigidities, or because money is not superneutral and thereforc expectations of future money supplies affect output [see Buiter (1981) and thd; references therein]. The empirical testing of the validity of this proposition is not, however, an entirely straightforward exercise. In part this reflects a well known observational equivalence problem first noted by Sargent (1976). Suppose output jfg and the money supply m, are generated by the following bivariate linear stochastic process: Yt=a,dkb't-I
1-11l%(l’)(m,-E,-,m,)+e,,,
“I am grateful for hclpfsll suggestions from participants at ?-eminars at ESE and Birbeck College and the comments of two referees. 001(1-2921/84/$3.00 ~$01984, Elsevier Science Pulnhshers B.V. (North-Holland)
C.R. Bean, MOW eoidence on tare U.K. natural rate hyporhesis
where a,,(E) i,j ==1,2 are (Ipossibly infinite) polynomials Pn the lag operator, and the ei, are serially uncorrelated and mutually independent shocks. Eq, ( 1) is the sort of reduced form which results from a ‘Classical’ model.’ Eq. (2) dexribes the evolution of the money stock. Taking expectations of (2) and substituting into (1) yields
=bt ,(i)y,
_
1
+b,,(L)m, +e,,.
(3)
13) is the sort of reduced form which might result from a ‘non&l’ model ih which anticipated policy plays a role. (This equation c=ontains no fiscal variables and is therefore clos,er in spirit to Friedman than Keynes.) Since ( 1) and (3) have the same error term they are statistically indistinguishable in the absence of, what must be essentially arbitrary, restrictions on the various lag polynomials. If, however, there is some variable which is known to appear in the money supply rule (2) but not in the redu@ form output eqs. (11 or (3) then the models can be distinguished. This is the approach taken by most researchers in this :Field;see, e.g., Barr0 (1977,1978), Leiderman (1980), Mishkia (1982a, b) and Pesaran (1982) for the U.S. and Attficld et al. (1981ia, b) for the UK. Barr0 for instance employs a federal spending variable and the lagged unemployment rate in this capacity while Attf’ield ct ai. use central government borrowing and the lagged current balance. A Keynesian economist, however, might feel uneasy about the assumption that such vztriables do not affect output and indeed Pesaran has argued that Barr-o’s results are more easily explained in a Keynesian framework- Consequently tests of the neutrality proposition carried out in this manner are unconvincing. An alternative approach, impleme:nted by Neftci and Sargent (1978) for the U *S-9 is to compare models across changes in policy regime because if (2) changes then (1) and (3) cannot both remain structurally stable. If changes iin regime can be identified it should be possible to provide more convincing tests of the neutrality proposition without r&sorting to debatable identifying assumptions. 2 I&e identification issue is dealt with at greater length by Abel .
cCali:~m (1979) has argued that, on theoretical grounds, only current monetary surprises should mai’xr in such models. However, tfi? presence of past values of unanticipated money ‘can ion lag are present. AJ’~er-nativeiyserially correlated shocks to the ‘surprise’ 1 be suficient to yield P reducxxi forrm like (1) with a serially uncorrelated the ne~ess~y filtering. is is tantamount to introducing into (2) additional dummy va iablesfor are zero be2re the break and take their true values after he break.
C.R. Bean, More euidcnce on the U.K. natural rate hypthesis
281
In this paper we apply this approach to quarterly data from the United Kingdom since 1963. Using both narrow (MI) and broad (EM.?) monetary aggregates, and short-term interest rates we find evidence of significant structural breaks in the authorities reaction function associated with the move to floating exchange rates in mid-1972 and the adoption of formal monetary targets in mid-1976 These breaks enable us to distinguish between ‘Classical’ models in which only unanticipated monetary policy matters and *non-Classical’ models in which anticipated policy also has real effects. ‘The evidence is not generally favourable to the neutrality proposition. 2. The money growtb equations It would seem almost incredible if given the upheavals of the last twenty years there had not been significant changes in the process describing the evolution of the money stock. One possibility might be simply to allow the coefflcienls describing the authorities behaviour to adjust gradually over time using the Kalman filter. However, there are three events which particularly stand out as likely to be associated with a change in policy regime. These are: the move to floating exchange rates in June 1972; the adoption of monetary targets during 1976; and the election of the Conservative government l?nder Mrs. Thatcher in May 1979. The second of these events is n,ot easy to date precisely. Formal targets for the rate of growth of M3 were first set during 1977, but official ‘forecasts’ were set somewhat earlier in mid-1976, and the corr,mitment to monetary discipline can be traced back somewhat earlier to the Chancellor’s Letter of Intent to the IMF in January 1976 which placed a ceiling on domestic credit expanlsion. We choose to locate any break between the second and third quarters of 1976 coinciding with the first publication of official ‘forecasts’ for the rate of growth of M.3. Policy reaction functions for two measures of the money stock were considlereld: MI which inclcdes sight deposits and notes and coin; and sterling A{3 which also includes time d:eposits with the banking sector. The last of these was the Bank of England’s chosen target aggregate over the latter part of the sample period but has been subject to quantitative controls - the ‘corset” - which encouraged disintermediation and is therefore likely to provide a distorted measure of monetary conditions. In addition since it does not include Building Society deposits which are a close substitute for time deposits with the banks, it is likely to be subject to movements which do not reflect any change in monetary stance. An additional difficulty with equations like (1) and (3) is that there may be contemporaneous feedback between output and the money stock. This is made especially likely in view Identification is then achieved 5~ assuming thellr absence from (1) and (3). Ijnless there is a reason to believe that (1) and (3) also shifted in an appropriate manner at the time of the break in policy regime, this does not seen’ unreasonable.
282
C.R. Bean, More evidence on the U.K. rraturai
rate hypothesis
of the fact that for most of this period the authorities actually operated by interest rates. ln this case it will be the innovation in interest rates than the money stock that is the exogenous driving force behind variations in output. .2We therefore also examined a policy reaction fr;nction describing the evolution of the 3-month Treasury Bill rate (R). These reaction functions were estimated over the period 1963Q34972Q2, 1972Q34976Q2, 197643-197941, and 1979Q2-198241. The explanatory variables in each case comprised two lagged values of the dependent variable (money stock variables are in logaritlm~), two lagged values of (the ariohm of) output, and two lagged values of (the logarithm of) prices, plus a constant and time trend. Barro and many other researchers generally assume that the rate of growth of the money stock depends only on past rates of growth, and not the levels, of the money stock. This specification is, of course, a particular case of the mod/e1con.sidered here. Since variables such as velocity - as a proxy for the tightness of credit markets perhaps - might aff& the authorities behaviour there is no reason to impose this feature a priori and indeed the estimates suggest it is an invalid restriction. Implicitly we therefore assume that private agents not only know that a change of regime has occurred, but also what the new policy rule is. This is in the spirit of the previous tests of neutrality which implicitly assume that private agents know the authorities rule and the econometrician does not, but it is clearly even less satisfactory. However, theoretical work on the transition to rational expectations is only just beginning and a practical alternative is not immediately apparent. Rcjlections of neutrality may therefore be essentially consistent with the New Classical model if the changes in regime lacked credibility or their implications were inadequately appreciated by private agents. The po’licy prescriptions of New Classical economists, however, do often tend to underplay the importance of such learning behaviour so at a minimum the results provide an eifaluation of this more extreme version of the New Classical view of the world. Table 1 presents the results of Chow tests4 of the null hypothesis of no structural break at the three dates for each of the three nionetary variables. In each case we have tested for heteroscedasticity associated with the change in regime. There is little evidence of a change in the residual variance of thle two monetary aggregates, but a marked tendency for the residual variance of interest rates to increase over the sample period. The Chow tests for a change in the evolution of interest rates have been corrected to allr 4 for this. A!1 three variables con&m a e;igGficant change in policy a.s$ p$ted wit11 the ‘Sargent and Wallace’s ( W75) strictures about the indeterminacy of the price level under an interest rate rule do not apply if the irqztzrestrate is manipulated to-hit ‘3 monetary target ex ante; see kkCa1hu-n (1981). Foughout the paper we use F rather than x2 tesis even Ithough only the asymptotic i-e known. Asymptotically the two are, of come, equivalent but the F test h-,s the g an (ad hoc) allowance for the loss of degrees of freedom in estimation.
C.R. Bean, More evidwce on thie U.K. natural rate hyporhds
283
Table 1 Tests of stability
of policy rules.” Dependent
variable
MI
fM3
Rh
08936)
3.62*
5.45”
5.39*
1976Q2/Q3” (i) F(8,ll) (ii) F(8,23)
3.66’ 3.82*
0.86 4.07*
3.59’ 4.43*
1979Ql/Q2
0.98
0.50
2.76
--Break at: 1972Q2/Q3
F(8.7)
-
“All test statistics cdistributed approximately as F with the indicated degrees of freedom. MI - Sight deposits plus notes and coin. EM3 -- MI plus time deposits. R - 3-month Treasury Bill rate. bTest statistics based on GLS estimates which correct for the change in the error variance between subperiods. “First row assumes s,truc:tural break at 1979Ql!Q2. Second row assumes no break here (see text). *Significant at 1% level. ‘Significant at 5”,6 lev’el.
mcve to floating exchange rates in 1972. There is also evidence of a further break in mid-1976 for MI and interest rates (row 2). Finally none of the variables suggest a si&rificant break in regime with the election of Mrs. Thatcher in early 1979. This, of course, does not necessarily imply that there was no significant change in policy because the test is 1ik;ely to be of rather low power due to the relatively small number of observations. Notwithstanding this we have also estimated policy reaction functions over the whol-e of the period 1976Q3-198241 and the Chow test now also indicate:; a significant break in mid-1976 for EM3 (row3). Estimates of these reaction functions., without a break for P&s. ‘Thatcher. are presented in table 2. To aid interpretation the results have been rewritten in terms of money growth rates, lagged velocity, lagged inflation, etc. Although in each case a number of the coefficients are insignificant on conventional st’atistical criteria, since wc do not have any strong prior that they are in fact zero, it does not seem appropriate to make further databasci:l exclusion restrictions. In any case any policy feedback rule obtained as a result of the imposition of data-based exclusion restrictions would necessarily have a similar fit and could be expected to generate a similar series for unanticipated policy. While the estimates are not precisely defined they tell a plausible story about, the evolution of policy qver this period Under the fixed exchange rate regime a divergence of output above trend would be likel;y to be associated with a trade deficit and thence to a monetary contraction. This constraint
~-
0.58 (2.8)
Lagged
0.20 (1.5)
Lagged nominal (YP-1 -+PI-1)
Bill rate. bGeneralised
A = diBerer,t
af-statistics
2.51
0.653
0.015
0.10 (0.4)
-0.25 (1.3)
-0.20 (0.6)
-1.40 (3.1)
1.65 (4.4)
@.i6 (0.8)
-0.015 !a.oj
3.65 (1.6)
72Q376Q2
76Q3-. 824 1
2.23
0.282
0.016
$I:
- 0.29 (0.6)
-0.11 (0.3)
- 0.66 (1.5)
0.42 (2.2)
0.67 (2.6)
0.006 (0.4)
-0.16 (0.1)
of M1 (dnr,)
2.12
0.441
0.012
-0.38 (1.8)
0.19 (1.6)
0.!4 (0.5)
- 0.28 (0.8)
0.27 (1.5)
0.24 (1.1)
-0.001 (0.3)
0.51 (0.4)
63Q3 72Q2 _
Growth
2.89
0.786
0.010
1.12 (4.6)
-0.34 (O-9)
- 0.69 (3.0)
-0.18 (0.8)
046 (2.2)
- 0.30 (1.4)
0.007 (0.4)
- 1.69 (0.6)
7642
?_?Qj-..
least squares estimate
allowing
for change in residual
variance
at 1979Ql/Q2.
_I
-
63Q.37202
53.8 (2.8) 45.7 (3.0) 0.78 0.602 2.72
42.7 (4.4) 0.39 9.489 2.08
- 19.1 (1.2)
24.4 (1.5)
- 1.68 (3.9)
0.66 (1.1)
2.6 (2.8)
165.3 (1.3)
72Q376Q2
in R (AR,)
- 19.3 f3.9)
- 11.7 (1.3)
(E)
- 0.82 (5.3)
0.61 (3.9)
0.12 (1.5)
- 28.0 (0.7)
-
Change
1.96
0.197
1.47
&
(&
$I;)
22.8 (05)
-0.43 (2.7,
0.61 (2.3)
-O.of) W)
-67.0 (0.4)
xi@&2CJ”
-
p, = log of price level, R, = rate of interest, plus time deposits, R = 3-month Treasury
1.75
0.194
0.012
-0.31 (1.4)
- =.a (1.3)
- 0.05 (0.1)
0.21 (0.6)
0.50 (2.3)
0.05 (0.2)
0.014 (1.4)
5.03 (l.f-9
824 1
7QQ3-
of f At.? (Ant,)
functions. PMb_____I__I_I
in parentheses. M, =log of relevant measure of money stock, y, = log of output, operator (Ax, = x, - x, - _ 1), Ml =sight deposits plus notes aud coin, f M3 = MI
2.21
Durbin-Watson
0.16 0.291
errcr
R2
Standard
Lagged output (YN) -0.51 (1.9)
0.21 (0.6)
Lqgged OutPut growth CAY,- ,)
income
--0.28 (0.6)
(Apt- 1)
Lagged inflation
UY~-~+p,-r-nei-JR,-,)
vzl -4yjR
0.35 (1.6)
Lagged monetary growth/ Change in R (Am, _ JAR, _ ,)
1.26 (0.8)
63Q37242
Growth
- 0.003 (1.0)
period:
PP..._
Time trend
Constant
Estimation __- -P
penden t variable:
P-e,
Table 2 Policy reaction
C.R. Bean, More evidence on the U.K. natrrra! rate hypothesis
285
was removed by the adoption of floating rates, and monetary poiicy becomes more accommodative. (Note the rise in the coefficients on lagged velocity and lagged output in the A41 and EM3 reaction functions and the large negative coefkient on the lagged level of interest rates indicating a reluctance to let interest rates rise.) The move to monetary targets in mid- 1976 is associated with a less accommodative poky, at least as judged by the MI and interest rate equations. ’ (Note the FE11in the coefficients on lagged velocity and lagged interest rates respectively and the greater inertia in MI growth.) A pertinent question is the rcbustness of these results Limited degrees of freedom prevent extensive specification searches, but auxiliary results do not suggest the need for addi?ional lags. More importantly Attfield et al. (198 la) present a money slupply rule for EM3 c-’ :itaining only the real values of the central government borrowing requirement and the lagged current account surplus in addition to lagged monetary growth, which is stable across the move to floating exchange rates. We have included these as additional explanatory variables in the policy reaction functions? In no case are they significant. By contrast lagged output and lagged prices are highly significant. As a consequence we may conclude that the failure of Attfield et al. to find a significant structural break may be associated with the inadequacy of their money supply rule. Indeed they note that the inclusion of other variables, including the inflation rate and lagged output, sometimes leads to a’ significant improvement in explanatory power, but reject these more general formulations on the grounds that ‘the coefficients obtained were frequently either implausible or unstable’ (p. 336). While implausibility may be grounds for excluding additional variables, instability certainly is not since there is a strong prior presumption that the behaviour of the mcnetary authorities has changed over the sample period. With such small sample5 there is, of course, a danger of overfitting and consequently explaining too much of the variation in interest rates or the money stock which will tend to lead to rejections of the neutrality proposition, Against this must be set the fact that there are undoubtedly a large number of additional variables which might help private agents predict the money stock and interest rates which are excluded from the regression. This will lead to us explaining too little of the variation and a tendency to fail to reject the neutrality proposition. The results presented here seem a reasonable compromise between the two extremes.
‘EM3 was heavily distorted over this period by the effects of the ‘corset’ and in the latter part by innovation in financial markets. The rise (fall) in the effect of lagged output in the MJ (interest rate) equations suggest that policy may actually have become more responsive to real shocks. 6The lagged real value of the borrowing requirement is used because the current V~&JI:is endogenous and unknown to agents at the start of the period when expectations are formel;l.
The results of section 2 suggest that it may be possible to test the s~tio~ that only unanticipated monetary policy affected activity over I-t982QI without recourse to debat’able identifying restrict equation. The variables in the output (GDP) elquations ing to ( I) and (3) include (initiaily) the current and four lagged of the policy variable in question (anticipated and unanticipatled), six value of output and prices (so that the only identifying restrictions ccme from the breaks in regime), plus a constant and a time trend to pick up owth in the natural rate and dummies for the miners’ strikes in nd 197441. Qf course, prices are an endogenous variable and hence t a true reduced form. However9 prices may be cot-related with variables which also affect demand in a ICeynesian world -- such as changes in commodity prices -- so including them provides a robust test of the policy neutrality proposition. Further (testable) exclusion restrictions imposed as required. The maximum lag length is imposed by onsiderations (twenty-four parameters from sixty-eight observations). hRishkin (1982a) notes that longer lagrs make rejection of the neutrality proposition more 1ikel;rand at a theoretical level it is difficult to argue the case for long lags from unanticipated policy except via state vari [McCallum (1979)], so that this is likely to be favourable to the neu proposition. In any case the gist of the results seems robust to variations in specification. T&e anticipated and unanticipated components are generated from the policy r~:+ion functions in taible 2. This is le:~sefficient than joint estimation of the reaction functtions and the output: equation a !a Attfield et al. and n. Rather more importantly the standard errors derived from the ‘twostep’ method wiIl not be correct and hence the test statistics quoted will not be distributed exactly as indicated. However, joint-estimation by non-linear methods is expensive and the results seem! sufficiently clear-cut not to make this worthwhileTable 3 presents the results of testing the neutrality proposition. For brevity the full rest&s are not reported, but the estimated equation standaud HOTS are 0.98”/&0.950/, and 0.88% where ,Mt, EM3 and the interest rate are the policy variables respectively. W? also examine the hypothesis that there is TNdifference between the effects of ;anticinated and unanticipated policy. This might be the view of an unri=constructed Keynesian or a Friedman&e monetarist, and is termed the ‘h~:mogene:ity’proposition. Finally in each case esr the significance of unarvGcipatec1(actual) policy variables under the of neutr paxity(homogeneity), together with the sig ol“the additional expla.natory variables. With both MI and interest e ~eu~raliity proposition is ‘ected at convene are unable to reject t proposition that
C.R. &an, Mare evidence on the U.K. natural ratr hypothesis
---
Table 3 Tests of neutrality and homogeneity.” m-pPohcy variable EM3
pR
2.13” 0.75
1.57 2.75”
3.36’ 1.67
0.50
I .94
1.87
MI
287
-
(a) With lagged prims
Neutrality F(5,44) Homogeneity F( 5,44) Significance of unanticipated policy with neutrality imposed F( 5,49) Significance of actual policy with homogeneity imposed F( 5.49) Lagged prices F(6,44) .b) Reduced form Neutrality F( 10,36) Homogeneity F( I f,36) Significance of unanticipated policy with neutrality imposed F( 11,46) Significance of actual policy with homogeneity imposed F( 10,47)
1.9Y 0.13 3.116” 2.26b
0.95
0.8 1 1.40
1.41
1.75
2.tIHb
1.03
1.42
,
3.76’ 1.72
2.68’ j-17
---
*Test statistics distributed approximately as F with degrees of freedom shown. Dependent variable is real output Ml =zSight Deposit: plus notes and coin, EM3= M d plus time deposits, R = 3-month Treasury Bill rate. bSignifkant at 57; level. “Significant at 1% level.
anticipated and unanticipated pc~‘icy tiffect activity in an iderrtical manner. These conclusions are reversed when fM3 is the poky variable: the homogeneity proposition is rejected, but the nieutrality proposition is not rejected I However, the policy variables are jointly signifkant in only the equation containing interest rates. Thus el!idence from this equation supports the view that it is actual rather than unanticipated policy that matters. while evidence from the MI and W3 equations IS rather more ambiguou:, since neither suggests a very significa-t influence of pohcy of either sort. li)f course this might not be too surprising to both a traditional monetarist who believes actual policy matters with ‘long and variable lags’ and ia NOW Classicist who believes that unanticipated policy only acts with a lag, is., qmonetary innovations Granger-cause output, since the lagged values of money/monetary innovations would be highly corr4ated with Fpast price movements. Consequently the lagged price terms might mask the ei&cts of past (but not carrent) movements/innovations in the money stock. The fact that lagged prices we s~g~~~~ant in these regressic ns is, however. evidence at factors other than the money stock, such as velocity shocks, have a signifiicant role in explaining output fluctuations.
288
CA. Bean, More evidence on the U.K. nafural rate hypothesis
If causation runs unidirectional)y from money to prices, i.e., money is strictly exogenous with respect to prices, then valid reduced form estimates of the ilnpactof monetary policy could be obtained by omitting prices from the res,sion. Ivow the results on the policy rule obtained above indicate this hypothesis cannot !IE maintained. Consequently reduced form estimates of the impact of anticiipatd policy will be biased in so far as they reflect the impact of omitted strictly exogenous variables. However, this cannot be the a with the unanticipated component of monetary policy since this is, by definition, strictly exogenous. Therefore a failure to find a significant impact of una.ntidpated policy in reduced form regressions is valid evidence against the view that monetary shocks have destabilised output, although a rejection 0C neutrality could be rational&d if it can be shown that there are genous variables which shifted the supply schedule and were also correlated with monetary growth. However, past researchers have almost invariably . employed a very simple specification of the supply function, so that a rejection of neutrality must represent evidence against such simple formulations of the model. Similarly a rejectic! , of homogeneity or ~‘1 Inability to identify an effect from anticipated ,olicy is not necessarily destructive to a non-Classical view of the world c account of the potential biases in the estimates of the coefficients on antlcipatec; money mentioned above. Reduced form estimates nxzst threfore be interpreted with some care. Table 3 (b) presents tests obtained from such reduced form regressions when lagged prices are omitted. At the same time the lags have been lengthened a little to ten quarters and the restriction that the anticipated level of the money stock have no long-run effect on activity imposed for the regressions which include MI and EM3 as the policy variable, a proposition whicth economists of most persuasions would iind acceptable. Lagged prices were not previously significant in the equation containing interest rates so the reduced form estimates of this equation provide valid reduced form Iestimates. Once again neutrality is rejected and homogeneity is accepted and there is strong evidence that it is actual rather than unanticipated policy that matters. For the two money stock variables neither neutrality nor homogeneity ten be rejected. However in neither case are the unanticipated policy variables significant (recall that these are valid estimates of thie impact of unanticipated policy even if the estimates of anticipated policy are biased). Consequently the reduced form estimates for the money stock variables might be interpreted as providing weak evidence against the evy Classical view that una,nticipated monetary shocks have been an lZ?pOictant CaUse of output fluc%ations. *ibble: 4 contains the results1 of simulating an anticipated and an unanticipated permanent 1% cirange Yn the m 3ney supply an4 a 5 point change in interest rates for the three reduced form estimates respectively. In the case of ated shock agerits are assumed to perceive correctly the new
C.R. Bean, More euidense on the U.K. natural rate hypot ht9si.s
289
Table 4 impulse responses -_-
---AMl
(“/ response of ourput). ~~------__
EM3
Lag (quarters)
Anticipated”
Unanticipatedb
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 00
0.03 0.13 0.07 0.17 0.18 0.37 0.40 0.42 0.55 0.37 0.34 0.26 0.24 0.20 0.16 Ct.15 0.12 0
0.16 0.19 0.26 0.36 0.29 0.19 0.20 0.22 0.41 0.35 0.07 0.09 0.09 0.03 0.04 0.03 0.02 0
Anticipated” 0.24 -0.16 -0.28 0.04 0.23 0.04 0.06 0.24 0.2 / 0.0 1 0.05 0.00 - 0.03 - 0.03 - 0.05 - 0.05 - 0.05 0
Unanticipatedb - 0.07 0.15 0.17 - 0.28 - 0.40 -0.44 - 0.77 - 0.99 -0.77 - 0.94 - 1.22 -1.11 - 1.14 - 1.10 - 1.01 - 0.94 - 0.85 0
R Anticipated” 0.01 0.01 0.03 Ct.02 0.02 0.00 0.00 -0.04 .- 0.07 -0.13 -0.18 - 0.23 -0.28 -C.?4 -0.40 - 0.46 -0.52
_-.. -.-
__ _
p--_ Unanticipatzdb 0.01 0.03 0.03 0.06 0.04 C.06 0.03 0.04 0.00 -0.04 - 0.08 -0.13 -0.18 - 0.23 -0.29 - 0.34 - 0.40
C
“Anticipated permanent step change of 1% in level of money stock (5 point change in interest rates). bU’nanticipated permanent step change of 1”~ in levei of money stock (5 point change in interest rates). ‘Long-run effects not defined.
level of the money stock (interest rates) in ensuing periods. For 1MI the ilmpact of an unanticipated change is around two and half times that of an anticipated change over the first year as would be expcted if unanticipated policy changes have a greater impact but this ranking is reversed in ensuing periods which seems somewhat paradoxical. AnGcipated changes in &W have a minimal expansionary effect on output as predicted by the New Classical view, but after the first few quarters the effect of an unanticipated chiange is quite perverse. “The regression with interest rates as the policy instrument is unfortunately unstable since the sum of the coefficients on lagged output very marginally (and quite insignificantly) exceeds unity. Consequently the long-run effects are not well defined. However, the equation may stiii give a useful guide to the short and medium-run effects of policy changes. Both anticipated and unanticipated interest rate increases reduce output with a consider;lble delay. The latter, however, actually appet:r to have a rather less depressing &ect than the former. This again seems lo run counter to a New Classical vit:w of the world although it could be rationalised in the context of an IS-LM-
CR. Rtwz, More cvidewe on the U.K. natural rate hypothesis
of money demand ‘Natural Rate model i?Fthe product. of the incorn,‘3Ialasticity y and the elasticity of goods demand with respect to real. balances exceeds unity. The most plausible picture of the economy seems to be one in which velocity responds passively to a rise in (actual) interest rates in the short run. After a year or so this leads to a fall in holdings of money balances and finally thence to a decline in real activity. A primary chaanel through which this change in output is broalght abt;ut is likely to be real exchange rate variations in at lelast the second half of the data sample. Since the neutrality proposition also suggests that anticipated monetary changes should not affect the composition of output, we have also inves-, tigated the impact on activity at an industry level. The quarterly output series from e:ighteen indus :rie~ over the same time period were combined to form a time-series crr>ss-section and u~i;d to provide a test of the neutr&ty proposition employing the same measures of anticipa&d and unanticipated money. The rest&s are broadly similar Ftith rejections of neutrality when Mi and interest rates are the policy variable, whereas those with EM3 as the policy variable are more favourablc to the hypothesis of neutrality. Policy sirns!ations are not dissimilar from ‘those in table 4 although the paradoxical effects from unanticipated money when MI and SM3 are the policy variables are attentuated somewhat. Fall results are contained in Bean (?983).
The results cast solme doubt on the neutrality proposition, at least when and interest rates are treated as the appropriate policy variable. On the er hand when the brnad aggregate EM3 is used neutrality cannot be rejected although the Gnulations of a policy shock are less easy to rationajise. This coin&t &tween the results with different policy measures is unfortunate, but perhaps not surprising since the time paths of MI and &M3 are very different over the sample period. In section 3 we argued that interest rates provide the best policy indicator on a priori grounds and that the EM3 series is heavily distorted by quantitative controls for much of the sample riod. fn so far as the work of Attfield et al. tend to support the NIX CL&al view for the UK., ii would therefore seem that a considerable part of the diEerence in results must be due to the choice of policy variable rather than the method of identification alone. There are a number of caveats, however, that must be made. First, as already indicated above, althou& the use of regime shifts to identify the model obviates the need fur contentious identifying assumptions concerning the nature of the reduced foim for output, it also introduces serious at the credibility of policy changes at the time and how long he parameters of the new
C.R. Bean, More evidence on the U.K. natural rate hypothrsis
291
not wish to underestimate the importance of such questions which have been largely ignored in the empirical work, but a fully satisfactory treatment is quite beyond the scope of the existing theory. Nevertheless we feel the results provide an antidote to some of the more extreme New Classical claims about olicy :irreIevance. Second, there is the question of the possible endogeneity of unanticipated policy changes, This was a major reason for focussing on interest rates as the most interesting policy measure. However, within quarter feedback is also possible here. In that case ir may be almost impossible to identify the effects of unanticipated policy for the reasons discussed by Pudncy (1982). The validity of the neutrality tests will be unaffected, however Finally, as in all empirical work, misspecification due to omitted variables could affect the results. Misspecification of the money growth equation by excluding relevant variables would serve to introduce measurement error into the unanticipated money variables and tend to bias their coeficients towards to zero. Unfortunately this may also affect the estimates of the impact of anticipated money because, a lthough anticipated and unanticipated money are contemporaneously uncorrelated, anticipated money will be correlated with past values of unanticipated money. Exclusion of relevant variables from the output equation could obviously affect the estimated coeficicnts on anticipated policy. The effects of unanticipated policy might also be biased if there are omitted variables which affect both output and monetai y growth. Data appendix Money Supply: Ml and EM3 ( amount outstanding, end of quarter, seasonally adjusted). Sotrrce: Economic Trends Annual Supplement. Bath series have been adjusted for changes in definition. Interest
rates:
Three-month Treasury Bill yield (last Friday of quarter). Source: Bank of England Statistical Abstract and Financial Statistics. Prices:
GDP Supplement .
deflator
(1975 = 100). Source:
Economic
Trends
Aggregate Output: GDP (output measure, 1975 = 100, seasonally Source: Economic Trends Annual Supplement.
Annual adjusted).
eferences Abel, A.B. and F.S. Mishkin, 1983, An integrated view of tests of rationality, market efficiency and the short-run neutrality of monetary policy, Journal of Monetary Economics 11, 3-24. Attlield, C.E.F., D. Demery and N.W. Duck, 1981a, A quarterly model of unanticipated monetary growth, output and the price leve! in the United Kingdorn 1963-1978, Journal oi Monetary Economics 8, 331-350. Attfield, C.L.F., D. Demery and N.W. Duck, 1981b. Unanticipated monetary growth, output and the price level: United Kingdom 1946-1977, EuropedAl Economic Review 16, 367-385.
292
CR. Brran, More evidence un the U.K. natural rate hypothesis
Rarro, RJ., 1977, Unanticipated money growth and unemployment in the United States, American Economic Review 67, 101-l 15. Barre, R.J., 1978, Unanticipated money, output. and the price level in the United States, Journal of Political Economy 86,549-§80. !kan, CR., 19g3, A little bit more evident on the natural rate hypothesis from the U.K., Centre for Labour Economics discussion paper 149 l(Londct School of Economics, London). &titer, W.H., 1981, The superiority of contingent rules over fixed rules in models with rational expectations, Economic Journal 91,647-670. Leiderman, L, 19f@, Macroeconomic testing of the rational expectations and structural neutrality hypoth~zk for the United States, J’ournal rof Monetary Economics 6, 69--82. Lucas, RX., 1973, Some international evidence on output - Inflation tradeoffs, American Economic Review 63, 326334. McCaltuzn, B.T., 1979, On the observational inequivalence of classical and Keynesian models, Journal of Political Economy 87,395-402. cCallum, B.T., 1981, Price level determinaey with an interest rate rule and rational expectations, Journal of Monetary Economics 8, 319-329. ~is~~~,i~, F.S., 1982a, Does anticipated monetary policy matter: An econometric investigation, Journal of Political Economy 90,22-51. Mishkin, FS., 1982b, roes anticipated aggregate demand policy matter? Further econometric results, American Economic Review 72,788-802. Muth. J-F., 1961, Rational expectakns and the theory of price movements, Econometrica 29, 3 15-355. Neki,, S.N. and T.J. Sargent, 1978, A little bit of evidence on the natural rate hypothesis from the U.S., Journal of Monetary Economics 4,315-320. Pearan, M-H., 1982, A critique of the proposed tests of the natural rate-rational expectations hypothesis, Economic Journal 92, S29-5.X Pudney, SE, 1982, The ideatifkation of rational expectations models under structural neutrality, Journal of Economic Dynamics and Control 4, 117-121. Sargent, T.J., 1976, The observational equivalence of natural and unnatural rate theories of macroeconomics, Journal of Political Economy 84,631-640. Sargent, TJ. and N. Wallace, 1975, Rational expectations, the optimal monetary instrument, and the optimal money supply rule, Journal of Political Economy 83, 241-254.
A LITTLE BIT MORE EVIDENCE ON THE NA AL RATE HYPOTHESIS FR0M THE UK. Charles IQ. BEAN* London School of Economic s, London WCZA 2AE, UK
Received February 1984, final version received July 1984 The evidence for the neutrality of anticipated changes in moaetary policy in the U.K. over the period 1963Ql--198241 is examined. Breaks in the stochastic process generating the money stock arc used to identify the model. The results, are generally unfavourable to the proposition that onl!s unanticipated money matters.
1. Introduction One of the most important propositions advanced in macroeconomics in the last decade concerns the impossibil.ity of systematic activist monetary policy. In an economy where the natural rate of output is independent of the rate of monetary growth, there are no rigidities and expectations are rational in the sense of ~Muth (1961) then anticipated changes in aggregate demand arising from attempts by the authorities to pursue a countercyclical monetary policy will already have been taken into account by agents when making their expenditure and output decisions and will therefore lead to no further response in activity. This neutrality proposition, associated especially with Lucas (1973), and Sargent and Wallace (1975), has prompted a number of authors to construct models with rational expectations in which there is nevertheless a role for a feedback monetary policy on account of informational asymmetries, supply-side rigidities, or because money is not superneutral and thereforc expectations of future money supplies affect output [see Buiter (1981) and thd; references therein]. The empirical testing of the validity of this proposition is not, however, an entirely straightforward exercise. In part this reflects a well known observational equivalence problem first noted by Sargent (1976). Suppose output jfg and the money supply m, are generated by the following bivariate linear stochastic process: Yt=a,dkb't-I
1-11l%(l’)(m,-E,-,m,)+e,,,
“I am grateful for hclpfsll suggestions from participants at ?-eminars at ESE and Birbeck College and the comments of two referees. 001(1-2921/84/$3.00 ~$01984, Elsevier Science Pulnhshers B.V. (North-Holland)
C.R. Bean, MOW eoidence on tare U.K. natural rate hyporhesis
where a,,(E) i,j ==1,2 are (Ipossibly infinite) polynomials Pn the lag operator, and the ei, are serially uncorrelated and mutually independent shocks. Eq, ( 1) is the sort of reduced form which results from a ‘Classical’ model.’ Eq. (2) dexribes the evolution of the money stock. Taking expectations of (2) and substituting into (1) yields
=bt ,(i)y,
_
1
+b,,(L)m, +e,,.
(3)
13) is the sort of reduced form which might result from a ‘non&l’ model ih which anticipated policy plays a role. (This equation c=ontains no fiscal variables and is therefore clos,er in spirit to Friedman than Keynes.) Since ( 1) and (3) have the same error term they are statistically indistinguishable in the absence of, what must be essentially arbitrary, restrictions on the various lag polynomials. If, however, there is some variable which is known to appear in the money supply rule (2) but not in the redu@ form output eqs. (11 or (3) then the models can be distinguished. This is the approach taken by most researchers in this :Field;see, e.g., Barr0 (1977,1978), Leiderman (1980), Mishkia (1982a, b) and Pesaran (1982) for the U.S. and Attficld et al. (1981ia, b) for the UK. Barr0 for instance employs a federal spending variable and the lagged unemployment rate in this capacity while Attf’ield ct ai. use central government borrowing and the lagged current balance. A Keynesian economist, however, might feel uneasy about the assumption that such vztriables do not affect output and indeed Pesaran has argued that Barr-o’s results are more easily explained in a Keynesian framework- Consequently tests of the neutrality proposition carried out in this manner are unconvincing. An alternative approach, impleme:nted by Neftci and Sargent (1978) for the U *S-9 is to compare models across changes in policy regime because if (2) changes then (1) and (3) cannot both remain structurally stable. If changes iin regime can be identified it should be possible to provide more convincing tests of the neutrality proposition without r&sorting to debatable identifying assumptions. 2 I&e identification issue is dealt with at greater length by Abel .
cCali:~m (1979) has argued that, on theoretical grounds, only current monetary surprises should mai’xr in such models. However, tfi? presence of past values of unanticipated money ‘can ion lag are present. AJ’~er-nativeiyserially correlated shocks to the ‘surprise’ 1 be suficient to yield P reducxxi forrm like (1) with a serially uncorrelated the ne~ess~y filtering. is is tantamount to introducing into (2) additional dummy va iablesfor are zero be2re the break and take their true values after he break.
C.R. Bean, More euidcnce on the U.K. natural rate hypthesis
281
In this paper we apply this approach to quarterly data from the United Kingdom since 1963. Using both narrow (MI) and broad (EM.?) monetary aggregates, and short-term interest rates we find evidence of significant structural breaks in the authorities reaction function associated with the move to floating exchange rates in mid-1972 and the adoption of formal monetary targets in mid-1976 These breaks enable us to distinguish between ‘Classical’ models in which only unanticipated monetary policy matters and *non-Classical’ models in which anticipated policy also has real effects. ‘The evidence is not generally favourable to the neutrality proposition. 2. The money growtb equations It would seem almost incredible if given the upheavals of the last twenty years there had not been significant changes in the process describing the evolution of the money stock. One possibility might be simply to allow the coefflcienls describing the authorities behaviour to adjust gradually over time using the Kalman filter. However, there are three events which particularly stand out as likely to be associated with a change in policy regime. These are: the move to floating exchange rates in June 1972; the adoption of monetary targets during 1976; and the election of the Conservative government l?nder Mrs. Thatcher in May 1979. The second of these events is n,ot easy to date precisely. Formal targets for the rate of growth of M3 were first set during 1977, but official ‘forecasts’ were set somewhat earlier in mid-1976, and the corr,mitment to monetary discipline can be traced back somewhat earlier to the Chancellor’s Letter of Intent to the IMF in January 1976 which placed a ceiling on domestic credit expanlsion. We choose to locate any break between the second and third quarters of 1976 coinciding with the first publication of official ‘forecasts’ for the rate of growth of M.3. Policy reaction functions for two measures of the money stock were considlereld: MI which inclcdes sight deposits and notes and coin; and sterling A{3 which also includes time d:eposits with the banking sector. The last of these was the Bank of England’s chosen target aggregate over the latter part of the sample period but has been subject to quantitative controls - the ‘corset” - which encouraged disintermediation and is therefore likely to provide a distorted measure of monetary conditions. In addition since it does not include Building Society deposits which are a close substitute for time deposits with the banks, it is likely to be subject to movements which do not reflect any change in monetary stance. An additional difficulty with equations like (1) and (3) is that there may be contemporaneous feedback between output and the money stock. This is made especially likely in view Identification is then achieved 5~ assuming thellr absence from (1) and (3). Ijnless there is a reason to believe that (1) and (3) also shifted in an appropriate manner at the time of the break in policy regime, this does not seen’ unreasonable.
282
C.R. Bean, More evidence on the U.K. rraturai
rate hypothesis
of the fact that for most of this period the authorities actually operated by interest rates. ln this case it will be the innovation in interest rates than the money stock that is the exogenous driving force behind variations in output. .2We therefore also examined a policy reaction fr;nction describing the evolution of the 3-month Treasury Bill rate (R). These reaction functions were estimated over the period 1963Q34972Q2, 1972Q34976Q2, 197643-197941, and 1979Q2-198241. The explanatory variables in each case comprised two lagged values of the dependent variable (money stock variables are in logaritlm~), two lagged values of (the ariohm of) output, and two lagged values of (the logarithm of) prices, plus a constant and time trend. Barro and many other researchers generally assume that the rate of growth of the money stock depends only on past rates of growth, and not the levels, of the money stock. This specification is, of course, a particular case of the mod/e1con.sidered here. Since variables such as velocity - as a proxy for the tightness of credit markets perhaps - might aff& the authorities behaviour there is no reason to impose this feature a priori and indeed the estimates suggest it is an invalid restriction. Implicitly we therefore assume that private agents not only know that a change of regime has occurred, but also what the new policy rule is. This is in the spirit of the previous tests of neutrality which implicitly assume that private agents know the authorities rule and the econometrician does not, but it is clearly even less satisfactory. However, theoretical work on the transition to rational expectations is only just beginning and a practical alternative is not immediately apparent. Rcjlections of neutrality may therefore be essentially consistent with the New Classical model if the changes in regime lacked credibility or their implications were inadequately appreciated by private agents. The po’licy prescriptions of New Classical economists, however, do often tend to underplay the importance of such learning behaviour so at a minimum the results provide an eifaluation of this more extreme version of the New Classical view of the world. Table 1 presents the results of Chow tests4 of the null hypothesis of no structural break at the three dates for each of the three nionetary variables. In each case we have tested for heteroscedasticity associated with the change in regime. There is little evidence of a change in the residual variance of thle two monetary aggregates, but a marked tendency for the residual variance of interest rates to increase over the sample period. The Chow tests for a change in the evolution of interest rates have been corrected to allr 4 for this. A!1 three variables con&m a e;igGficant change in policy a.s$ p$ted wit11 the ‘Sargent and Wallace’s ( W75) strictures about the indeterminacy of the price level under an interest rate rule do not apply if the irqztzrestrate is manipulated to-hit ‘3 monetary target ex ante; see kkCa1hu-n (1981). Foughout the paper we use F rather than x2 tesis even Ithough only the asymptotic i-e known. Asymptotically the two are, of come, equivalent but the F test h-,s the g an (ad hoc) allowance for the loss of degrees of freedom in estimation.
C.R. Bean, More evidwce on thie U.K. natural rate hyporhds
283
Table 1 Tests of stability
of policy rules.” Dependent
variable
MI
fM3
Rh
08936)
3.62*
5.45”
5.39*
1976Q2/Q3” (i) F(8,ll) (ii) F(8,23)
3.66’ 3.82*
0.86 4.07*
3.59’ 4.43*
1979Ql/Q2
0.98
0.50
2.76
--Break at: 1972Q2/Q3
F(8.7)
-
“All test statistics cdistributed approximately as F with the indicated degrees of freedom. MI - Sight deposits plus notes and coin. EM3 -- MI plus time deposits. R - 3-month Treasury Bill rate. bTest statistics based on GLS estimates which correct for the change in the error variance between subperiods. “First row assumes s,truc:tural break at 1979Ql!Q2. Second row assumes no break here (see text). *Significant at 1% level. ‘Significant at 5”,6 lev’el.
mcve to floating exchange rates in 1972. There is also evidence of a further break in mid-1976 for MI and interest rates (row 2). Finally none of the variables suggest a si&rificant break in regime with the election of Mrs. Thatcher in early 1979. This, of course, does not necessarily imply that there was no significant change in policy because the test is 1ik;ely to be of rather low power due to the relatively small number of observations. Notwithstanding this we have also estimated policy reaction functions over the whol-e of the period 1976Q3-198241 and the Chow test now also indicate:; a significant break in mid-1976 for EM3 (row3). Estimates of these reaction functions., without a break for P&s. ‘Thatcher. are presented in table 2. To aid interpretation the results have been rewritten in terms of money growth rates, lagged velocity, lagged inflation, etc. Although in each case a number of the coefficients are insignificant on conventional st’atistical criteria, since wc do not have any strong prior that they are in fact zero, it does not seem appropriate to make further databasci:l exclusion restrictions. In any case any policy feedback rule obtained as a result of the imposition of data-based exclusion restrictions would necessarily have a similar fit and could be expected to generate a similar series for unanticipated policy. While the estimates are not precisely defined they tell a plausible story about, the evolution of policy qver this period Under the fixed exchange rate regime a divergence of output above trend would be likel;y to be associated with a trade deficit and thence to a monetary contraction. This constraint
~-
0.58 (2.8)
Lagged
0.20 (1.5)
Lagged nominal (YP-1 -+PI-1)
Bill rate. bGeneralised
A = diBerer,t
af-statistics
2.51
0.653
0.015
0.10 (0.4)
-0.25 (1.3)
-0.20 (0.6)
-1.40 (3.1)
1.65 (4.4)
@.i6 (0.8)
-0.015 !a.oj
3.65 (1.6)
72Q376Q2
76Q3-. 824 1
2.23
0.282
0.016
$I:
- 0.29 (0.6)
-0.11 (0.3)
- 0.66 (1.5)
0.42 (2.2)
0.67 (2.6)
0.006 (0.4)
-0.16 (0.1)
of M1 (dnr,)
2.12
0.441
0.012
-0.38 (1.8)
0.19 (1.6)
0.!4 (0.5)
- 0.28 (0.8)
0.27 (1.5)
0.24 (1.1)
-0.001 (0.3)
0.51 (0.4)
63Q3 72Q2 _
Growth
2.89
0.786
0.010
1.12 (4.6)
-0.34 (O-9)
- 0.69 (3.0)
-0.18 (0.8)
046 (2.2)
- 0.30 (1.4)
0.007 (0.4)
- 1.69 (0.6)
7642
?_?Qj-..
least squares estimate
allowing
for change in residual
variance
at 1979Ql/Q2.
_I
-
63Q.37202
53.8 (2.8) 45.7 (3.0) 0.78 0.602 2.72
42.7 (4.4) 0.39 9.489 2.08
- 19.1 (1.2)
24.4 (1.5)
- 1.68 (3.9)
0.66 (1.1)
2.6 (2.8)
165.3 (1.3)
72Q376Q2
in R (AR,)
- 19.3 f3.9)
- 11.7 (1.3)
(E)
- 0.82 (5.3)
0.61 (3.9)
0.12 (1.5)
- 28.0 (0.7)
-
Change
1.96
0.197
1.47
&
(&
$I;)
22.8 (05)
-0.43 (2.7,
0.61 (2.3)
-O.of) W)
-67.0 (0.4)
xi@&2CJ”
-
p, = log of price level, R, = rate of interest, plus time deposits, R = 3-month Treasury
1.75
0.194
0.012
-0.31 (1.4)
- =.a (1.3)
- 0.05 (0.1)
0.21 (0.6)
0.50 (2.3)
0.05 (0.2)
0.014 (1.4)
5.03 (l.f-9
824 1
7QQ3-
of f At.? (Ant,)
functions. PMb_____I__I_I
in parentheses. M, =log of relevant measure of money stock, y, = log of output, operator (Ax, = x, - x, - _ 1), Ml =sight deposits plus notes aud coin, f M3 = MI
2.21
Durbin-Watson
0.16 0.291
errcr
R2
Standard
Lagged output (YN) -0.51 (1.9)
0.21 (0.6)
Lqgged OutPut growth CAY,- ,)
income
--0.28 (0.6)
(Apt- 1)
Lagged inflation
UY~-~+p,-r-nei-JR,-,)
vzl -4yjR
0.35 (1.6)
Lagged monetary growth/ Change in R (Am, _ JAR, _ ,)
1.26 (0.8)
63Q37242
Growth
- 0.003 (1.0)
period:
PP..._
Time trend
Constant
Estimation __- -P
penden t variable:
P-e,
Table 2 Policy reaction
C.R. Bean, More evidence on the U.K. natrrra! rate hypothesis
285
was removed by the adoption of floating rates, and monetary poiicy becomes more accommodative. (Note the rise in the coefficients on lagged velocity and lagged output in the A41 and EM3 reaction functions and the large negative coefkient on the lagged level of interest rates indicating a reluctance to let interest rates rise.) The move to monetary targets in mid- 1976 is associated with a less accommodative poky, at least as judged by the MI and interest rate equations. ’ (Note the FE11in the coefficients on lagged velocity and lagged interest rates respectively and the greater inertia in MI growth.) A pertinent question is the rcbustness of these results Limited degrees of freedom prevent extensive specification searches, but auxiliary results do not suggest the need for addi?ional lags. More importantly Attfield et al. (198 la) present a money slupply rule for EM3 c-’ :itaining only the real values of the central government borrowing requirement and the lagged current account surplus in addition to lagged monetary growth, which is stable across the move to floating exchange rates. We have included these as additional explanatory variables in the policy reaction functions? In no case are they significant. By contrast lagged output and lagged prices are highly significant. As a consequence we may conclude that the failure of Attfield et al. to find a significant structural break may be associated with the inadequacy of their money supply rule. Indeed they note that the inclusion of other variables, including the inflation rate and lagged output, sometimes leads to a’ significant improvement in explanatory power, but reject these more general formulations on the grounds that ‘the coefficients obtained were frequently either implausible or unstable’ (p. 336). While implausibility may be grounds for excluding additional variables, instability certainly is not since there is a strong prior presumption that the behaviour of the mcnetary authorities has changed over the sample period. With such small sample5 there is, of course, a danger of overfitting and consequently explaining too much of the variation in interest rates or the money stock which will tend to lead to rejections of the neutrality proposition, Against this must be set the fact that there are undoubtedly a large number of additional variables which might help private agents predict the money stock and interest rates which are excluded from the regression. This will lead to us explaining too little of the variation and a tendency to fail to reject the neutrality proposition. The results presented here seem a reasonable compromise between the two extremes.
‘EM3 was heavily distorted over this period by the effects of the ‘corset’ and in the latter part by innovation in financial markets. The rise (fall) in the effect of lagged output in the MJ (interest rate) equations suggest that policy may actually have become more responsive to real shocks. 6The lagged real value of the borrowing requirement is used because the current V~&JI:is endogenous and unknown to agents at the start of the period when expectations are formel;l.
The results of section 2 suggest that it may be possible to test the s~tio~ that only unanticipated monetary policy affected activity over I-t982QI without recourse to debat’able identifying restrict equation. The variables in the output (GDP) elquations ing to ( I) and (3) include (initiaily) the current and four lagged of the policy variable in question (anticipated and unanticipatled), six value of output and prices (so that the only identifying restrictions ccme from the breaks in regime), plus a constant and a time trend to pick up owth in the natural rate and dummies for the miners’ strikes in nd 197441. Qf course, prices are an endogenous variable and hence t a true reduced form. However9 prices may be cot-related with variables which also affect demand in a ICeynesian world -- such as changes in commodity prices -- so including them provides a robust test of the policy neutrality proposition. Further (testable) exclusion restrictions imposed as required. The maximum lag length is imposed by onsiderations (twenty-four parameters from sixty-eight observations). hRishkin (1982a) notes that longer lagrs make rejection of the neutrality proposition more 1ikel;rand at a theoretical level it is difficult to argue the case for long lags from unanticipated policy except via state vari [McCallum (1979)], so that this is likely to be favourable to the neu proposition. In any case the gist of the results seems robust to variations in specification. T&e anticipated and unanticipated components are generated from the policy r~:+ion functions in taible 2. This is le:~sefficient than joint estimation of the reaction functtions and the output: equation a !a Attfield et al. and n. Rather more importantly the standard errors derived from the ‘twostep’ method wiIl not be correct and hence the test statistics quoted will not be distributed exactly as indicated. However, joint-estimation by non-linear methods is expensive and the results seem! sufficiently clear-cut not to make this worthwhileTable 3 presents the results of testing the neutrality proposition. For brevity the full rest&s are not reported, but the estimated equation standaud HOTS are 0.98”/&0.950/, and 0.88% where ,Mt, EM3 and the interest rate are the policy variables respectively. W? also examine the hypothesis that there is TNdifference between the effects of ;anticinated and unanticipated policy. This might be the view of an unri=constructed Keynesian or a Friedman&e monetarist, and is termed the ‘h~:mogene:ity’proposition. Finally in each case esr the significance of unarvGcipatec1(actual) policy variables under the of neutr paxity(homogeneity), together with the sig ol“the additional expla.natory variables. With both MI and interest e ~eu~raliity proposition is ‘ected at convene are unable to reject t proposition that
C.R. &an, Mare evidence on the U.K. natural ratr hypothesis
---
Table 3 Tests of neutrality and homogeneity.” m-pPohcy variable EM3
pR
2.13” 0.75
1.57 2.75”
3.36’ 1.67
0.50
I .94
1.87
MI
287
-
(a) With lagged prims
Neutrality F(5,44) Homogeneity F( 5,44) Significance of unanticipated policy with neutrality imposed F( 5,49) Significance of actual policy with homogeneity imposed F( 5.49) Lagged prices F(6,44) .b) Reduced form Neutrality F( 10,36) Homogeneity F( I f,36) Significance of unanticipated policy with neutrality imposed F( 11,46) Significance of actual policy with homogeneity imposed F( 10,47)
1.9Y 0.13 3.116” 2.26b
0.95
0.8 1 1.40
1.41
1.75
2.tIHb
1.03
1.42
,
3.76’ 1.72
2.68’ j-17
---
*Test statistics distributed approximately as F with degrees of freedom shown. Dependent variable is real output Ml =zSight Deposit: plus notes and coin, EM3= M d plus time deposits, R = 3-month Treasury Bill rate. bSignifkant at 57; level. “Significant at 1% level.
anticipated and unanticipated pc~‘icy tiffect activity in an iderrtical manner. These conclusions are reversed when fM3 is the poky variable: the homogeneity proposition is rejected, but the nieutrality proposition is not rejected I However, the policy variables are jointly signifkant in only the equation containing interest rates. Thus el!idence from this equation supports the view that it is actual rather than unanticipated policy that matters. while evidence from the MI and W3 equations IS rather more ambiguou:, since neither suggests a very significa-t influence of pohcy of either sort. li)f course this might not be too surprising to both a traditional monetarist who believes actual policy matters with ‘long and variable lags’ and ia NOW Classicist who believes that unanticipated policy only acts with a lag, is., qmonetary innovations Granger-cause output, since the lagged values of money/monetary innovations would be highly corr4ated with Fpast price movements. Consequently the lagged price terms might mask the ei&cts of past (but not carrent) movements/innovations in the money stock. The fact that lagged prices we s~g~~~~ant in these regressic ns is, however. evidence at factors other than the money stock, such as velocity shocks, have a signifiicant role in explaining output fluctuations.
288
CA. Bean, More evidence on the U.K. nafural rate hypothesis
If causation runs unidirectional)y from money to prices, i.e., money is strictly exogenous with respect to prices, then valid reduced form estimates of the ilnpactof monetary policy could be obtained by omitting prices from the res,sion. Ivow the results on the policy rule obtained above indicate this hypothesis cannot !IE maintained. Consequently reduced form estimates of the impact of anticiipatd policy will be biased in so far as they reflect the impact of omitted strictly exogenous variables. However, this cannot be the a with the unanticipated component of monetary policy since this is, by definition, strictly exogenous. Therefore a failure to find a significant impact of una.ntidpated policy in reduced form regressions is valid evidence against the view that monetary shocks have destabilised output, although a rejection 0C neutrality could be rational&d if it can be shown that there are genous variables which shifted the supply schedule and were also correlated with monetary growth. However, past researchers have almost invariably . employed a very simple specification of the supply function, so that a rejection of neutrality must represent evidence against such simple formulations of the model. Similarly a rejectic! , of homogeneity or ~‘1 Inability to identify an effect from anticipated ,olicy is not necessarily destructive to a non-Classical view of the world c account of the potential biases in the estimates of the coefficients on antlcipatec; money mentioned above. Reduced form estimates nxzst threfore be interpreted with some care. Table 3 (b) presents tests obtained from such reduced form regressions when lagged prices are omitted. At the same time the lags have been lengthened a little to ten quarters and the restriction that the anticipated level of the money stock have no long-run effect on activity imposed for the regressions which include MI and EM3 as the policy variable, a proposition whicth economists of most persuasions would iind acceptable. Lagged prices were not previously significant in the equation containing interest rates so the reduced form estimates of this equation provide valid reduced form Iestimates. Once again neutrality is rejected and homogeneity is accepted and there is strong evidence that it is actual rather than unanticipated policy that matters. For the two money stock variables neither neutrality nor homogeneity ten be rejected. However in neither case are the unanticipated policy variables significant (recall that these are valid estimates of thie impact of unanticipated policy even if the estimates of anticipated policy are biased). Consequently the reduced form estimates for the money stock variables might be interpreted as providing weak evidence against the evy Classical view that una,nticipated monetary shocks have been an lZ?pOictant CaUse of output fluc%ations. *ibble: 4 contains the results1 of simulating an anticipated and an unanticipated permanent 1% cirange Yn the m 3ney supply an4 a 5 point change in interest rates for the three reduced form estimates respectively. In the case of ated shock agerits are assumed to perceive correctly the new
C.R. Bean, More euidense on the U.K. natural rate hypot ht9si.s
289
Table 4 impulse responses -_-
---AMl
(“/ response of ourput). ~~------__
EM3
Lag (quarters)
Anticipated”
Unanticipatedb
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 00
0.03 0.13 0.07 0.17 0.18 0.37 0.40 0.42 0.55 0.37 0.34 0.26 0.24 0.20 0.16 Ct.15 0.12 0
0.16 0.19 0.26 0.36 0.29 0.19 0.20 0.22 0.41 0.35 0.07 0.09 0.09 0.03 0.04 0.03 0.02 0
Anticipated” 0.24 -0.16 -0.28 0.04 0.23 0.04 0.06 0.24 0.2 / 0.0 1 0.05 0.00 - 0.03 - 0.03 - 0.05 - 0.05 - 0.05 0
Unanticipatedb - 0.07 0.15 0.17 - 0.28 - 0.40 -0.44 - 0.77 - 0.99 -0.77 - 0.94 - 1.22 -1.11 - 1.14 - 1.10 - 1.01 - 0.94 - 0.85 0
R Anticipated” 0.01 0.01 0.03 Ct.02 0.02 0.00 0.00 -0.04 .- 0.07 -0.13 -0.18 - 0.23 -0.28 -C.?4 -0.40 - 0.46 -0.52
_-.. -.-
__ _
p--_ Unanticipatzdb 0.01 0.03 0.03 0.06 0.04 C.06 0.03 0.04 0.00 -0.04 - 0.08 -0.13 -0.18 - 0.23 -0.29 - 0.34 - 0.40
C
“Anticipated permanent step change of 1% in level of money stock (5 point change in interest rates). bU’nanticipated permanent step change of 1”~ in levei of money stock (5 point change in interest rates). ‘Long-run effects not defined.
level of the money stock (interest rates) in ensuing periods. For 1MI the ilmpact of an unanticipated change is around two and half times that of an anticipated change over the first year as would be expcted if unanticipated policy changes have a greater impact but this ranking is reversed in ensuing periods which seems somewhat paradoxical. AnGcipated changes in &W have a minimal expansionary effect on output as predicted by the New Classical view, but after the first few quarters the effect of an unanticipated chiange is quite perverse. “The regression with interest rates as the policy instrument is unfortunately unstable since the sum of the coefficients on lagged output very marginally (and quite insignificantly) exceeds unity. Consequently the long-run effects are not well defined. However, the equation may stiii give a useful guide to the short and medium-run effects of policy changes. Both anticipated and unanticipated interest rate increases reduce output with a consider;lble delay. The latter, however, actually appet:r to have a rather less depressing &ect than the former. This again seems lo run counter to a New Classical vit:w of the world although it could be rationalised in the context of an IS-LM-
CR. Rtwz, More cvidewe on the U.K. natural rate hypothesis
of money demand ‘Natural Rate model i?Fthe product. of the incorn,‘3Ialasticity y and the elasticity of goods demand with respect to real. balances exceeds unity. The most plausible picture of the economy seems to be one in which velocity responds passively to a rise in (actual) interest rates in the short run. After a year or so this leads to a fall in holdings of money balances and finally thence to a decline in real activity. A primary chaanel through which this change in output is broalght abt;ut is likely to be real exchange rate variations in at lelast the second half of the data sample. Since the neutrality proposition also suggests that anticipated monetary changes should not affect the composition of output, we have also inves-, tigated the impact on activity at an industry level. The quarterly output series from e:ighteen indus :rie~ over the same time period were combined to form a time-series crr>ss-section and u~i;d to provide a test of the neutr&ty proposition employing the same measures of anticipa&d and unanticipated money. The rest&s are broadly similar Ftith rejections of neutrality when Mi and interest rates are the policy variable, whereas those with EM3 as the policy variable are more favourablc to the hypothesis of neutrality. Policy sirns!ations are not dissimilar from ‘those in table 4 although the paradoxical effects from unanticipated money when MI and SM3 are the policy variables are attentuated somewhat. Fall results are contained in Bean (?983).
The results cast solme doubt on the neutrality proposition, at least when and interest rates are treated as the appropriate policy variable. On the er hand when the brnad aggregate EM3 is used neutrality cannot be rejected although the Gnulations of a policy shock are less easy to rationajise. This coin&t &tween the results with different policy measures is unfortunate, but perhaps not surprising since the time paths of MI and &M3 are very different over the sample period. In section 3 we argued that interest rates provide the best policy indicator on a priori grounds and that the EM3 series is heavily distorted by quantitative controls for much of the sample riod. fn so far as the work of Attfield et al. tend to support the NIX CL&al view for the UK., ii would therefore seem that a considerable part of the diEerence in results must be due to the choice of policy variable rather than the method of identification alone. There are a number of caveats, however, that must be made. First, as already indicated above, althou& the use of regime shifts to identify the model obviates the need fur contentious identifying assumptions concerning the nature of the reduced foim for output, it also introduces serious at the credibility of policy changes at the time and how long he parameters of the new
C.R. Bean, More evidence on the U.K. natural rate hypothrsis
291
not wish to underestimate the importance of such questions which have been largely ignored in the empirical work, but a fully satisfactory treatment is quite beyond the scope of the existing theory. Nevertheless we feel the results provide an antidote to some of the more extreme New Classical claims about olicy :irreIevance. Second, there is the question of the possible endogeneity of unanticipated policy changes, This was a major reason for focussing on interest rates as the most interesting policy measure. However, within quarter feedback is also possible here. In that case ir may be almost impossible to identify the effects of unanticipated policy for the reasons discussed by Pudncy (1982). The validity of the neutrality tests will be unaffected, however Finally, as in all empirical work, misspecification due to omitted variables could affect the results. Misspecification of the money growth equation by excluding relevant variables would serve to introduce measurement error into the unanticipated money variables and tend to bias their coeficients towards to zero. Unfortunately this may also affect the estimates of the impact of anticipated money because, a lthough anticipated and unanticipated money are contemporaneously uncorrelated, anticipated money will be correlated with past values of unanticipated money. Exclusion of relevant variables from the output equation could obviously affect the estimated coeficicnts on anticipated policy. The effects of unanticipated policy might also be biased if there are omitted variables which affect both output and monetai y growth. Data appendix Money Supply: Ml and EM3 ( amount outstanding, end of quarter, seasonally adjusted). Sotrrce: Economic Trends Annual Supplement. Bath series have been adjusted for changes in definition. Interest
rates:
Three-month Treasury Bill yield (last Friday of quarter). Source: Bank of England Statistical Abstract and Financial Statistics. Prices:
GDP Supplement .
deflator
(1975 = 100). Source:
Economic
Trends
Aggregate Output: GDP (output measure, 1975 = 100, seasonally Source: Economic Trends Annual Supplement.
Annual adjusted).
eferences Abel, A.B. and F.S. Mishkin, 1983, An integrated view of tests of rationality, market efficiency and the short-run neutrality of monetary policy, Journal of Monetary Economics 11, 3-24. Attlield, C.E.F., D. Demery and N.W. Duck, 1981a, A quarterly model of unanticipated monetary growth, output and the price leve! in the United Kingdorn 1963-1978, Journal oi Monetary Economics 8, 331-350. Attfield, C.L.F., D. Demery and N.W. Duck, 1981b. Unanticipated monetary growth, output and the price level: United Kingdom 1946-1977, EuropedAl Economic Review 16, 367-385.
292
CR. Brran, More evidence un the U.K. natural rate hypothesis
Rarro, RJ., 1977, Unanticipated money growth and unemployment in the United States, American Economic Review 67, 101-l 15. Barre, R.J., 1978, Unanticipated money, output. and the price level in the United States, Journal of Political Economy 86,549-§80. !kan, CR., 19g3, A little bit more evident on the natural rate hypothesis from the U.K., Centre for Labour Economics discussion paper 149 l(Londct School of Economics, London). &titer, W.H., 1981, The superiority of contingent rules over fixed rules in models with rational expectations, Economic Journal 91,647-670. Leiderman, L, 19f@, Macroeconomic testing of the rational expectations and structural neutrality hypoth~zk for the United States, J’ournal rof Monetary Economics 6, 69--82. Lucas, RX., 1973, Some international evidence on output - Inflation tradeoffs, American Economic Review 63, 326334. McCaltuzn, B.T., 1979, On the observational inequivalence of classical and Keynesian models, Journal of Political Economy 87,395-402. cCallum, B.T., 1981, Price level determinaey with an interest rate rule and rational expectations, Journal of Monetary Economics 8, 319-329. ~is~~~,i~, F.S., 1982a, Does anticipated monetary policy matter: An econometric investigation, Journal of Political Economy 90,22-51. Mishkin, FS., 1982b, roes anticipated aggregate demand policy matter? Further econometric results, American Economic Review 72,788-802. Muth. J-F., 1961, Rational expectakns and the theory of price movements, Econometrica 29, 3 15-355. Neki,, S.N. and T.J. Sargent, 1978, A little bit of evidence on the natural rate hypothesis from the U.S., Journal of Monetary Economics 4,315-320. Pearan, M-H., 1982, A critique of the proposed tests of the natural rate-rational expectations hypothesis, Economic Journal 92, S29-5.X Pudney, SE, 1982, The ideatifkation of rational expectations models under structural neutrality, Journal of Economic Dynamics and Control 4, 117-121. Sargent, T.J., 1976, The observational equivalence of natural and unnatural rate theories of macroeconomics, Journal of Political Economy 84,631-640. Sargent, TJ. and N. Wallace, 1975, Rational expectations, the optimal monetary instrument, and the optimal money supply rule, Journal of Political Economy 83, 241-254.