Recession and Recovery in the United Kingdom in the 1990s: A Vector Autoregression Approach


WP/95/40-EA
Recession and Recovery in the United Kingdom in the 1990s:
A Vector Autoregression Approach by Luis Cat o and Ramana Ramaswamy

The U.K. economy experienced one of its worst postwar recessions in
1990-92, when output declined by a cumulative 3 1/2 percent. This paper
uses a vector autoregression (VAR) model to identify the shocks that were
instrumental in causing the recession. The VAR approach is particularly
useful when there are no strong priors about what caused the recession; it
allows competing hypotheses of the recession to be distinguished without
imposing many restrictions on the data.

The main finding of this paper is that the recent recession in the
United Kingdom was precipitated primarily by shocks to consumption. This
stands in marked contrast to the experience in 1979-81, when investment
shocks were the main cause of the recession. The VAR analysis indicates
that consumption shocks have a long lasting effect on GDP and, hence, offers
a potential explanation for the long duration of the recession as well. The
nature of the recovery taking place in the United Kingdom is shown to be
basically consistent with the results of the model.

The VAR approach also allows a decomposition of the impact of monetary
policy and expectational shocks on activity. The results of the paper
indicate that the recent recession can be explained only in part by the
prior monetary tightening and the subsequent collapse of the housing market.
Expectational shocks are shown to have been equally important in bringing
about the recession.