The pattern of real exchange rates has changed significantly since February. Our currency forecasts at that time were in line with the implied forward rates in financial markets, with the yen projected to appreciate slowly against the dollar, rising from 100 to the dollar in the first quarter of 1995 to around 90 to the dollar in 1997. Within Europe, we projected a further small appreciation of the D-mark and a continuing depreciation of the lira and the peseta. Overall, we expected ‘real exchange rates to stay approximately stable’. In the event, the yen rose strongly in March and April to around 80 to the dollar, while the D-mark rose from around 1.50 to 1.38 to the dollar. At the same time, the lira/D-mark exchange rate fell by over 10 per cent and the Exchange Rate Mechanism was placed under renewed strain, with both the peseta and the escudo being devalued. As a result, the Japanese and US real effective exchange rates are respectively 15 per cent higher and 7 per cent lower than we had previously expected. These developments also had a wider impact on financial markets. The discount rate was cut in Japan and Germany and long-term rates rose in Italy and Spain. Equity prices fell sharply in those countries with appreciating currencies and jumped up in most of the countries whose exchange rate has depreciated.

P. J. Forsyth and J. A. Kay have recently argued, in a widely quoted article, that the enjoyment of the benefits of North Sea oil is only possible if there is a contraction of manufacturing output. Their argument has been mis interpreted in some quarters and it is here re-examined and placed in a wider context. The note was written by G. D. N. Worswick.

The yield of income tax varies automatically with movements in personal income as well as with discretionary changes in tax rates and allowances. In forecasting and for historical appraisal of fiscal policy there is a need to specify the automatic relationship between tax and income movements. In the former case this means specifying an accurate direct tax function in the forecasting model (i.e., identifying endogenous tax movements). From the descriptive, historical, point of view, it is possible to use such a function both to understand the ‘built-in’ properties of the budgetary system and, at the same time, to create a more complete picture of budgetary intervention than is given by the treatment of discretionary changes alone as indicators of fiscal policy. The latter procedure, which arises from the traditional British approach to budget-making (while not necessarily an inaccurate way of formulating policy), does tend to prevent an accurate picture of the complete Government intervention being formed by observers, and may result in expenditure, tax and monetary decisions being taken and analysed in a fragmented framework.

The past few weeks have seen an intensification of the banking crisis in the United States, with the near failure of Bear Sterns, although some commentators hopefully say that the worst has now passed. In the United Kingdom the gap between the Bank Rate and money market rates has re-opened and is described as indicative of a reluctance of banks to lend to each other. In this commentary we seek to explain the fundamental factors behind recent developments in UK lending markets. We begin by describing the recent experience of the financial services industry in the United Kingdom and putting the crisis, which has been described as the worst since the Second World War, into some sort of perspective.

This article uses a dataset covering ten advanced economies (Australia, Belgium, Canada, France, Germany, Netherlands, Norway, Sweden, United Kingdom and the United States) to explore the role of real wages as an influence on employment and unemployment in the Great Depression and more generally in the 1920s and 1930s. The distinction between employment and unemployment movements during the Great Depression helps to clarify the role of supply side influences on the national heterogeneity of unemployment increases during the Great Depression. We find little general econometric evidence for the idea that movements in product wages had strong influences on employment either during the period of rising unemployment associated with the depression of the 1930s or more generally with the data which exist for the 1920s and 1930s.

In this article we propose a policy framework for inflation targeting that contains elements of both optimal and simple rules. We use a simple feedback rule for the interest rate to look after monetary policy in the long run whilst using optimal control in the short run to determine appropriate responses to shocks. The composite policy is capable of substantial welfare improvements over using a simple rule alone whilst maintaining tractability. We see the use of such a framework together with a fully specified model as a feasible approach to practical policy design.

The global economy expanded by 5.3 per cent in 2006, one of the fastest rates of growth in the past 35 years. We project further expansions of 5 per cent this year and 4¾ per cent in 2008. The key risks to the forecast that we highlight in this Review relate to global housing markets and the current stance of monetary policy. The US economy is restrained by the recent correction in its housing market, which is expected to continue to weigh on the economy through 2008. There is some concern that the housing investment downturn may spread to other economies, and in this report we explore the areas most at risk to such a contagion. We also consider the recent volatility in the oil price, which makes it difficult for monetary authorities to distinguish signal from noise. If too much emphasis is placed on what subsequently turns out to be noise, policy settings could turn out to be overly lax or stringent.

We investigate trends in regional cost competitiveness in China's four regions (Coastal, Northeast, Interior and West) over the past thirty-five years. We find that the Coastal region lost its initial cost competitiveness as its higher relative labour productivity (RLP) was offset by rapidly rising relative nominal labour costs (RNLC) due to rising wages. The Northeastern region still has cost advantages in the traditional Manufacturing sector. The Interior and West regions improved their competitiveness in most industries due to low RNLCs. There is convergence of relative unit labour cost (RULC) in all industries before 1995, but only in Finance after 1995. However there is convergence in RLP in five industries in 1978–95 and 1995–2009, offering prospects for robust growth for China into the future.

Macro Modelling Notes is a new section of the Review, which we hope will appear on a regular basis. It will contain a small number of very short papers that have arisen from applied macro modelling work at the Institute or elsewhere. In the course of building and operating macro models, a large amount of information is used and produced that may never enter the public domain. This may be because the information is not substantial enough to justify a whole journal article, or because it is specific to the practice of using a macro econometric model. However this information is often of general interest to other economists, and is nearly always helpful to other macro modellers. This section is designed as an outlet for information of this kind, which might otherwise not be published in any readily accessible form.

The three notes below provide three different examples of this type of note. The first involves econometric practice, and shows how long-run standard errors can be simply derived using standard regression techniques. The second presents some econometric results on export pricing obtained during normal ‘model maintenance’ of our world model GEM. The third considers the problem of setting terminal dates for a consistent expectations model.

This new section of the Review is designed as a vehicle for all UK and overseas macro modellers, and therefore outside submissions are strongly encouraged. Submissions must be of about the length of the notes shown here, and contain relevant material that does not form part of a larger article soon to be published. Unlike Review articles, these notes will not normally be refereed, but the Editorial Board may consult expert advice when necessary.

I discuss six tools available to monetary policy makers. Three of these have been used since the inception of central banking. Three are new and were introduced in the aftermath of the 2008 financial crisis. I argue that, when the UK Monetary Policy Committee raises the interest rate, it should maintain a large balance sheet that consists of both risky and safe assets. Further, the Bank should trade the risk composition of its balance sheet to promote the stability of asset prices.