Abstract

It is tempting to give a very short answer to the title of the session—raise interest rates and reduce monetary growth. But when and by how much? That raises two questions which are central to the design of monetary policy. First, starting from an inflationary episode, how quickly should inflation be reduced to its desired level? Second, should monetary policy react to shocks to output as well as to inflation? The two questions are closely related and are the subject of this paper. Both questions were faced by the United Kingdom following departure from the exchange rate mechanism (ERM) in September 1992. At that time, the latest published inflation rate (retail price inflation excluding mortgage interest payments) was 4.2 percent, but that was following a recession during which output fell, relative to trend, by almost 10 percent, and the sterling effective exchange rate had just depreciated by 13 percent. The policy challenge was to prevent the depreciation having second-round effects on wages and prices, and to keep inflation falling during a recovery in output that had already started.

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