5  The real exchange rate shock is likely to push down on domestic demand but should increase export supply. 4  BIS central bankers’ speeches  disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output”.6 In other words, if shocks drive inflation sufficiently away from the target, the MPC are allowed to choose how quickly to return inflation to 2% and should explain such policy decisions via the open letter system. I have often been asked whether or not changes to the target, or the remit, or to CPI itself would help us to set policy. The answer is a clear no. Of course, the Government can decide to change these things if it wants to, but that wouldn’t magic away the problem. The unfortunate and difficult truth is that the shocks that have hit the economy recently have not been caused by monetary conditions. They are real economy shocks which make us individually and collectively worse off – we have to pay more tax, we have to pay more, in real terms, for petrol, gas, electricity and imported goods or services. The choice that monetary policymakers face is how much of these relative price shocks should be accommodated by a higher level of prices, and how much should be accommodated by a squeeze on nominal wages (and higher unemployment).
At its heart, a model – any model – is just a framework for thinking about an issue, be it how the economy reacts to different shocks, how the setup of a car might affect the way it handles a corner, or how a disease might spread through a population. As all modellers would concede, they can only provide an approximation of reality, which is always far more complex. That isn’t to say that models aren’t useful – far from it. Economic models, like any other, are essential. But they are not a panacea. For example, it would be a mistake to think one can just keep learning and adding to a single economic model until it gets ever more complete. What tends to happen is that one just ends up with a very large model which nobody can understand or use for any practical purpose. Instead, the best way forward in understanding the economy seems to be to use a variety of different models, remembering the relative strengths and weaknesses of each, and applying judgment accordingly. That is exactly what the MPC does when it considers the appropriate stance of monetary policy. The Bank’s approach to modelling strives to be eclectic. 6  The remit can be found at http://www.bankofengland.co.uk/monetarypolicy/pdf/chancellorletter110323.pdf  BIS central bankers’ speeches  5  What about forecasts? They too are essential, given that the lags between setting policy and its impact on inflation require us to be forward-looking.