Macroeconomic Shocks and Monetary Policy : Analysis of Sweden and the United Kingdom

Abstract: External economic shocks cause domestic macroeconomic aggregates to fluctuate. This may call for a macroeconomic policy intervention. Since the early 1990s an increasing number of countries have adopted an inflation targeting framework. In reality, inflation targeters do not have perfect information when determining the interest rate in order to maintain their goal of price stability and stable economic growth. Therefore it is relevant to understand how shocks affect the domestic macroeconomic aggregates theoretically and investigate whether the theoretical predictions hold empirically. I use the New Keynesian model by Clarida, Galí and Gertler from 1999 and investigate explicitly the theoretical effects of expected and unexpected supply and demand-side shocks on the monetary policy instrument and the two monetary policy target variables – the interest rate, output gap and inflation rate. By analysing the impulse-response functions of a structural VAR model applied to quarterly Swedish and British data from 1994 to 2011, I test empirically the theoretical predictions according to the New Keynesian model. I find that the empirical results are in line with the theoretical predictions.