Working Paper no. 117
By Shamik Dhar and Stephen P Millard
In this paper we develop a model of the UK economy in which monetary growth determines inflation, but in which multiple shocks obscure the relationship between money and inflation. It is a general equilibrium model, calibrated to match certain key features of the data, and it falls into the class of ‘limited participation’ models, popularised by Lucas (1990), Fuerst (1992) and Christiano and Eichenbaum (1992, 1995). Our version closely follows that of Christiano and Gust (1998), but with the addition of investment adjustment costs. We show that the model is able to capture important features of the monetary transmission mechanism in the United Kingdom, as embodied in the responses of variables to monetary policy shocks.