Asymmetric Interest Rate Effects for the UK Real Economy*

Date01 September 2002
Published date01 September 2002
DOIhttp://doi.org/10.1111/1468-0084.00028
Asymmetric Interest Rate Effects for the UK
Real Economy*
Marianne Sensier
,Denise R. Osborn
and Nadir O
¨cal
à
Centre for Growth and Business Cycle Research, School of Economic Studies,
University of Manchester, UK email: marianne.sensier@man.ac.uk
à
Middle East Technical University, Ankara, Turkey
I. Introduction
The role of interest rates in the UK economy is a very topical issue. Since the
Bank of England was given responsibility in 1997 for controlling inflation, its
Monetary Policy Committee has used short-term interest rates as the tool for
achieving its inflationary target. Although it is widely acknowledged that
monetary policy also affects the real economy, the extent of this influence
remains an issue for debate. Therefore, when considering possible trade-offs
between failure to meet its inflation target and possible adverse effects of
interest rate increases on real activity, the Monetary Policy Committee has no
firm foundation on which to judge the latter.
One specific area of debate concerns asymmetries in the effects of
monetary policy on the real economy. Such asymmetry was widely accepted
by economists in the period subsequent to the Great Depression, when
monetary policy was seen as ineffective in combating recession (Johnson,
1962, p.365). Linear models, with their implied symmetry, held sway during
the 1970s and 1980s, but a number of recent empirical studies have again
returned to the issue and found evidence of asymmetry. One strand of this
literature is based on regime-switching models with the regime defined in
terms of the value (sometimes simply the sign) of a monetary variable. Many
studies of this type have been undertaken for the US, including Choi (1999),
*Financial support from the Leverhulme Trust and ESRC grant L138251002 is gratefully ac-
knowledged. We also acknowledge that the GAUSS programs used here derive from programs made
available by Timo Tera¨svirta. We would like to thank Dick van Dijk, Mike Artis, Ian Garrett, Mehtap
Kesriyeli and an anonymous referee for helpful comments and other assistance.
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 64, 4 (2002) 0305-9049
315
Blackwell Publishers Ltd, 2002. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350
Main Street, Malden, MA 02148, USA.
Cover (1992), DeLong and Summers (1988), Morgan (1993) and Ravn and
Sola (1996), while Karras (1996) considers European countries. All these
authors find evidence of asymmetry, with different effects on real output of
shocks to money or interest rates depending on the monetary regime.
The second strand of this literature returns to the postwar issue of the
effectiveness of monetary policy over the phases of the business cycle, by
assuming that nonlinearity is associated with the growth of output. In this
context, Garcia and Schaller (1995) find that US monetary policy is more
effective during recessions than expansions; similar results are also obtained
by Weise (1999). On the other hand, Thoma (1994) finds asymmetry
associated with both the sign of the monetary shock and the business cycle
phase, with negative shocks having greater effects in periods of high growth.
For the task of predicting US recessions, the studies of Anderson and Vahid
(2001) and of Estrella and Mishkin (1998) emphasise the importance of the
interest rate spread. In the UK context, Simpson, Osborn and Sensier (2001)
investigate a business cycle regime model for output growth, with the regime
transition probabilities functions of interest rate changes. They find that large
increases in interest rates affect the expansion to recession probability, with
little role for interest rates in the switch from recession to expansion. Their
findings are compatible with the initial postwar view that interest rates are
ineffective in combating recession, but contrast to recent US results of Garcia
and Schaller (1995) and Weise (1999).
Most of the studies referred to above use small vector autoregressive
(VAR) systems to capture the interrelationships between the real and monetary
variables under study. These VAR systems typically either assume that the
same type of nonlinearity (arising through common regimes defined in terms
of a single variable) applies to all equations of the system, or that the
nonlinearity is confined to the output equation. Either of these assumptions is
contentious.
Of the studies that justify the use of nonlinear models from the perspective
of economic theory, Cover (1992), Morgan (1993), Ravn and Sola (1996) and
Weise (1999) all use arguments based on prices being less flexible downward
than upward. It is indisputable that relative downward price inflexibility may
be a source of nonlinearity in these models, but placing too strong a reliance
on this explanation ignores other possible sources of nonlinearity. One such
source has been highlighted in recent research that has explicitly investigated
the nature of monetary policy rules used by central banks. Here evidence has
been found of asymmetry in the design of monetary policy, with this
asymmetry associated either with the sign of the deviation of inflation from its
target or with the phases of the business cycle; see Bec et al. (2002) and
Dolado et al. (2000). Such asymmetry not only renders inadequate any linear
equation for the monetary variable(s), but also supports the view that different
316 Bulletin
Blackwell Publishers 2002

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