Did High-Powered Money Rule the Roost? Monetary Policy, Private Behaviour and the Structure of Interest Rates in the United Kingdom: 1972–77

Abstract

Asset Price Expectation Formation (APEX) equations are derived by inverting theoretically plausible asset demand functions under the maintained assumptions of continuous market clearing and unbiased expectations. In this paper, I argue that APEX equations can be used in empirical research aimed at circumventing the Lucas critique. The results of this work suggest that the mean-variance model with rational expectations can explain a significant proportion of the movement in UK asset returns during 1972–7. The results also suggest that the authorities’ avowed strategy of pegging short-term interest rates was correctly perceived by private agents and incorporated into their estimate of the covariance matrix of asset returns. A by-product of this study is that descriptive models of the variance of a time series do not necessarily contain any information about the risks and welfare losses actually incurred by agents facing this data.