This paper estimates a simple structural model of monetary policy in the UK focusing on the policy of inflation targeting introduced in 1992. We find that: (i) the adoption of inflation targeting led to significant changes in monetary policy; (ii) post-1992 monetary policy is asymmetric as policy-makers respond more to upward deviation of inflation away from the target; (iii) post-1992 policy-makers may be attempting to keep inflation within the 1.4%-2.6% range rather than pursuing a point target of 2.5% and (iv) the response of monetary policy to inflation is nonlinear as interest rates respond more when inflation is further from the target.

This paper argues that the rate of equilibrium unemployment depends on the objectives of the Central Bank. In a model where the Central Bank uses monetary policy to stabilise the economy, we show that unemployment and in¯ation will be lower with an in¯ation target than with targets for output, money or nominal GDP. The intuition for this is that the elasticities of demand in both the product and the labour markets are greater when there is an in¯ation target; we show that this leads to a lower mark-up of price over marginal cost and makes wages more sensitive to unemployment.

We thank Amar Radia, Ryan Banerjee and Christopher Bowdler for very useful comments and suggestions.

We analyse UK monetary policy using monthly data for 1992-2010. We have two main findings. First, the Taylor rule breaks down after 2007 as the estimated response to inflation falls markedly and becomes insignificant. Second, policy is best described as a weighted average of a "financial crisis" regime in which policy rates respond strongly to financial stress and a "no-crisis" Taylor rule regime. Our analysis provides a clear explanation for the deep cuts in policy rates beginning in late 2008 and highlights the dilemma faced by policymakers in 2010-11.

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