Changes in the Relationship between Short‐Term Interest Rate, Inflation and Growth: Evidence from the UK, 1820–2014

Abstract

This paper examines the dynamic relationship between interest rates, inflation and economic growth using a long dataset for the UK. The approach adopted enables us to identify structural breaks in the dynamic system (vector autoregression (VAR)). We find interest rates respond much more strongly to growth and inflation over recent decades, and forecast error variance decomposition analysis indicates there is increasing interconnectedness between the variables in recent years. Economic policymakers need to carefully monitor the linkages between these variables and be prepared to adjust their monetary policy tools when faced with structural changes.

Keywords: inflation, growth, short term interest rate, structural breaks, VAR

JEL Classification: C12, C32, E20, G12, G15