-1-
Flattened Inflation-Output Tradeoff and
Enhanced Anti-Inflation Policy as an
Outcome of Globalization
The Analytics of the Effects of Globalization
by
Assaf Razin and Alon Binyamini
-2-
The paper provides a unified analysis of
globalization effects on the Phillips curve and
monetary policy, in a New-Keynesian framework.
The main proposition of the paper is twofold.
Labor, goods, and capital mobility flatten the
tradeoff between inflation and activity. If policy
makers are guided by the welfare criterion of the
representative household, globalization forces also
lead monetary policy to be more aggressive with
regard to inflation fluctuations but, at the same
time, more benign with respect to the
output-gap fluctuations.
-3-
1. Introduction
Charles Bean (2006) writes about the UK tradeoff:
”One of the most notable developments of the past
decade or so has been the apparent flattening of the
short-run trade-off between inflation and activity.
That is particularly obvious in the case of the United
Kingdom, but can also be observed in many other
countries. The seventies were characterized by an
almost vertical relationship in the United Kingdom,
in which attempt to hold unemployment below its
natural rate resulted in rising inflation.
eighties,
the
downward
sloping
In the
relationship
-4-
reappears, as inflation was squeezed out of the
system by the slack of the economy. However, since
the early Nineties, the relationship looks to have been
rather flat. Three factors - increased specialization;
the intensification of product market competition;
and the impact of that intensified competition and
migration on the behavior of wages--should all work
to flatten the short-run tradeoff between inflation and
domestic activity.”
-5-
Ken Rogoff (2003, 2004) elaborates on some
favorable factors that have been helping to drive
down global inflation in the last two decades. The
hypothesis, which he put forth, is that the
“globalization—interacting with deregulation and
privatization—has played a strong supporting role
in the past decade’s disinflation.”
-6-
2. Analytical Framework
The analytical framework draws on the recent
New-Keynesian macroeconomics literature (See
Woodford (2003)). Main features of the openeconomy New- Keynesian model are:
(1) The domestic economy produces a continuum
of differentiated goods. Decisions of the
representative household are governed by DixitStiglitz preferences (generating fixed elasticities).
Purchasing power parity conditions prevail for
the flexible price goods and foreign firms' prices
are taken as exogenous.
-7-
(2) The representative-household utility is defined
over consumption and leisure, as in the standard
micro-based welfare analysis.
(3) There is international trade in goods and
financial assets.
(4) Labor supply is divided between domestic and
foreign destinations. Exported labor receive wage
premium over unskilled foreign labor. Imported
labor is unskilled and native born labor
commands an endogenously determined skill
premium.
-8-
(5) Price updates are staggered (see Calvo (1983)).
Namely, producers update prices upon receiving a
signal drawn from a stochastic distribution.
(6) World prices are exogenous (that is, the
“small open economy” assumption).
(7) There is free international trade in goods
and bonds.
-9-
Household


1
home


1 h

j     htexp  j 
M


t
Max E0   uCt ; t   
 dj  ( t , t ) 
0
1
Pt


t 0



t
(1)

1
 1
 1
n
  1
Ct    cH ,t    dj   cW ,t    dj 
n
0

Where
n
varieties,
(2)
is the number of domestically produced
1 n
is the number of foreign produced
varieties.
The budget constraint:
Pt Ct  PtTt  M t  BH ,t   t BW ,t  1  iH ,t 1 BH ,t 1  1  iW ,t 1  t BW ,t 1 
1
M t 1  tH wtH  hthom e  j   dj   t  tw wtw  htexp  j   dj    t  j dj
n
1
0
n
0
(3)
- 10 -
Where:
Wage rate of unskilled labor in the domestic
market.
w 
Wage rate of unskilled labor in the foreign
market.
 
Skill premium of the native born labor.
wtH 
w
t
H
t
Skill premium, for the domestic native born
labor, in the foreign market.
Exchange rate in period t.
 
tw 
t
Free migration of unskilled labor implies that
w   w .
H
t
t
w
t
- 11 -
Producers

 1
1
 1
1

yt  j   At  (1  )   hthom e  j       htimp  j  


(4)
We assume that natives are more skilled then the
migrants.
Hence,   0, 12  .


The marginal productivity of native labor is
higher function then that of immigrant labor,
hence the wage of the native workers includes skill
premium over the wage of immigrants,
tH  1
.
- 12 -
Labor Market
Labor supply satisfies the following first order
conditions:
uc Ct ; t  
uc Ct ; t  
 H  t wtw
Pt
 w t wtw
Pt




 hthome  j   htexp  j 

   hthom e  j   htexp  j 

(5)
(6)
The labor disutility home bias and the relative
skill premium:
tw

tH
(7)
- 13 -
Real marginal cost
1 
MC t  j   Z t  y t  j 

(8)
Where, the term
1 
yt  j  
reflects the diminishing marginal productivity of
labor;
The
Zt 
1

Zt

term:
1 1
1
At

 tw wtw
1
 1
 1

 tw  11 

1       ( ) 



 
;
the foreign real in domestic currency units is
w 
w
t
 t  Wt w
Pt
.
If the labor market is open to out-migration but
closed to in-migration, then
- 14 Z tout 
1

1 1


1
At

 tw wtw
1
 1





1




 
Z tout  Z t
That is, in-migration exerts a lowering cost effect
akin to a technological progress.
To see the effect of out-migration on the marginal
cost compare the mc with no migration
MC tclosed  j   Z tclosed 
Z tclosed 
1


1  
1
yt  j  
u c (Yt )
1
1
1
At

1  
( 1)(1 )

with the mc with out- migration
1 
MC t  j   Z t  y t  j 
Zt 
1


1 1
1
At



 tw wtw
1
 1
 1

 tw  11 




 ( ) 
 1 



 
- 15 -
MC becomes less output elastic with outward
migration: compare out -migration output
elasticity compared to no out -migration
output elasticity
. This is in line with the
flattening of the aggregate supply schedule--next.
1 

1  

3. The Aggregate Supply
3.1 Open Capital Account, Open Trade
Account, and in-and out-migration
When there is perfect mobility of goods, then
domestic producers specialize,
1>n.
Perfect mobility of capital implies perfect
consumption smoothing; that is


Ct  CtN
- 16 -
The approximated aggregate supply curve is derived
from the log linearization of the
aggregate supply equations, around a purely
deterministic steady state.
Upper hat denotes proportional deviation from the
purely deterministic steady state, and
the superscript N denotes the "natural" value of real
variables, that is, the value of a variable that would
have prevailed under completely flexible prices.
- 17 -
Bench mark case: perfect mobility of labor, goods
and capital


 t  E t  t 1






  p  n y tH  y tN    p  (1  n) y tF  y tN   qˆ tl 
1   p
1  n   1    q c  q c     q c  1    E q c 


t
t 1 
t t 1  
 t
n  





(10)
(1   )(1   )

If the labor market is closed, then the aggregatesupply curve becomes:
t  Ett 1
 


   n ytH  ytN     (1  n ) ytF  ytN     Ct  Ctn 
1  
1  n   1    q c  q c     q c  1    E q c 


 t
t
t 1 
t t 1 
n  




(8)
Open Capital Account, Open Trade
Account; Closed Labor Market
t  Ett 1


   n  y tH  y tN     (1  n ) y tF  y tN 
1  
1  n   1    q c  q c     q c  1    E q c 


 t
t
t 1 
t t 1 
n  




(9)
- 18 -
Open Trade Account; Closed Capital
Account and Closed Labor Market
If the domestic economy is not integrated to the
international financial market, then there
is no possibility of consumption smoothing, and we
have that the value of aggregate current spending
equals the value of aggregate domestic output:


PCt Cˆ t  PYt Yˆt

;

PCt is the CPI-based price level and
GDP deflator.

PCt Cˆ  PYt Yˆt N
N
t

PYt is the
- 19 t  Ett 1


 n        y tH  y tN     (1  n ) y tF  y tN 
1  
1  n   1    q c  q c     q c  1    E q c 


 t
t
t 1 
t t 1 
n  




(10)
Closed Economy
Because with the closed trade account, the
consumption of each good equal domestic
production of the good, production is fully
diversified.
Namely, 1 = n .
If, in addition, the goods and capital mobility is shut
off and in- and out-migration is not possible,
- 20 -




N
t
Ct  Yt , CtN  Y
t  Ett 1


      ytH  ytN 
1  
(11)
- 21 -
Slope of the Aggregate Supply Curve
This means that in every successive round of the
opening up of the economy, globalization
contributes to flatten the aggregate supply curve.
The intuition is that when an economy opens up to
trade in goods, it tends to specialize in production
but to diversify in consumption. This means the
number of domestically produced goods (= n ),
- 22 -
is less then the number of domestically consumed
goods (= 1). Consequently, the commodity
composition of the consumption and output
baskets, which are identical if the trade account is
closed, are different when trade in goods is
possible. As a result, the correlation between
fluctuations in output and in consumption (which
is equal to unity in the case of a closed trade
account) is less than unity if the economy is
opened to international trade in goods.
- 23 -
1   
n  p
(1   p )
(Perfect mobility of Labor,
Capital and Goods y).
2   
n
(1   )
(Closed Labor Market; Perfect
mobility of Capital and Goods).
3   
(n   )
(1   )
(Closed Labor Market; closed
Capital Account; Open Trade
account).
4   
(   )
(1   )
1   2   3   4
(Closed economy).
.
This means that in every successive round of
opening
the
economy,
globalization
contributes to flatten the aggregate supply
curve. The intuition is as follows.
- 24 -
When an economy opens up to trade in goods,
it tends to specialize in production and
diversify in consumption, as is well known.
This means the number of domestically
produced goods (which is equal to n), is less
then the number of domestically consumed
goods (which is equal to 1). Consequently, the
commodity composition of the consumption
and output baskets, which are identical in a
closed economy, are different when trade in
goods is possible. As a result, the correlation
between the fluctuations in output and
consumption (which is equal to 1 in the case
of a closed economy) is weakened if the
economy is opened to international trade in
goods. This means that the effects of supply
- 25 -
shocks on inflation are also weakened under
the open good market regime.
When the economy is financially open, then
the correlation between the fluctuations in
consumption and domestic output is farther
weakened, since the representative household
can
smooth
consumption
through
international borrowing and lending. The
inflation effects of shocks to marginal costs
are reduced, because the fluctuations in labor
supply are smoothed, as a consequence of
consumption smoothing.
When the economy opens up, for in- and outlabor migration, the labor supply and
demand elasticities increase; which help to
moderate
the
response
variability of output gap.
of
inflation
to
- 26 -
When the capital account is open, then the correlation
between fluctuations in consumption and domestic
output is farther weakened, this is because with open
capital account the representative household can
smooth consumption through international
borrowing and lending and thereby separate current
consumption from current output.
The inflation effects of shocks to the marginal cost
are therefore reduced, because the fluctuations in
labor supply are also smoothed, as a consequence of
the consumption smoothing.
Out-migration reduces the output elasticity of the
marginal cost (compare equation (8)
- 27 -
and equation (9)). This implies that, in the presence
of out-migration, shocks to domestic
output will have smaller effects on inflation,
compared to a closed economy.
When the economy opens up to in-migration, the
proportional factor of the marginal
cost curve is lowered. Therefore, the effect of
demand shocks on inflation is weakened.
- 28 -
4. Utility-based loss function
We abstract from in adequate money balances in
the equilibrium and take the monopolistic
competition as correctable by output subsidies.
The key distortions in the New-Keynesian
equilibrium can be grouped into two types:
(1) Because consumption smoothing is desirable,
fluctuations of the output gap, which are
correlated with consumption, reduce welfarereducing.
(2) Because an efficient allocation of the labor
supply implies an equal division of labor across
differentiated goods (recall that the disutility of
labor is a convex function), any cross good
- 29 -
dispersion in output is distortionary. Given that
not all the prices are updated simultaneously,
inflation generates a distortion.
The Woodford (2003) transformation:

2
L  E0   t t2    ytH  ytN 

t 0

(12)
Where  , the relative weight of output gap in the
loss function, is
ratio, and
1


1
  SR
( SR denotes the sacrifice
is proportional to the flexible-price
mark up).
It follows from our previous discussion that this
weight gets smaller with openness. The relative
weight of output stabilization in the loss function
is equal to:
1 
 n  p

 (1   p )
and Goods y).
(Perfect mobility of Labor, Capital
- 30 -
2 

n

 (1   )
(Closed Labor Market; Perfect
mobility of Capital and Goods).
3 
 (n   )

 (1   )
(Closed Labor Market; closed Capital
Account; Open Trade account).
4 
 (   )

 (1   )
(Closed economy).
1  2  3  4 .
Opening up an economy to trade in goods and capital flows
weakens the correlation between the fluctuations in the
output gap and the fluctuations in consumption. Recall
that the representative household welfare depends on
consumption, not on domestic output. Therefore, the
output-gap weight in the loss function falls as an economy
opens up to trade, and capital assets.
- 31 -
With migration, the representative household’s income and
output are separated, one
from the other. Because consumption level is associated
with the income level (not GDP
levels), fluctuations of domestic output become less
important to the representative
household compared to the case of no migration. Thus, the
output-gap weight in the loss
function declines when migration is allowed.
We thus establish that the output-gap weight in the utilitybased loss function decreases
with the opening up of the economy, in every successive
round of opening up.
5. Optimal Monetary Policy Under Discretion
- 32 -
The approximated aggregate demand equation is:

N
xt  Et xt 1   ( i H , t  Et  t 1  r t )
1
N
rt
is the deviation of the natural rate of real
interest, from steady state.
The approximated (real) interest-parity equation
is:




q t  Et q 1t  ( i F , t  Et F , t 1 )  ( i H , t  Et  t 1 )
- 33 -
The optimal monetary policy rule is obtained by
choosing the path of t

 t , xt ,
and

qt
so as to minimize the loss function in
equation (14), subject to the aggregate supply
equation, aggregate demand equation and the
(real) interest parity rule, in every period
t=1,2,…
The utility-based interest rule is:
N


i H , t  r t     E t  t  1   x xt   u u t
(13)
where tu collects terms from the right hand side of
the aggregate supply curve (apart
- 34 -
from the inflation expectations and the output
gap) and where the elasticity of the policy
determined interest rate, with respect to the
inflation expectations, depends on the degree
of openness, as follows:
 q 
1 

  
1

 
   1
1   ( 1   q )
x 
 [1   ( 1   q ) 1}

Where
q 
(1  n)
(1     )
n
is the aggregate-supply elasticity
of inflation, with respect to the real exchange rate.
Note that in the closed economy case
   1
x 
1

1   ( 4 )
 [1   42

 q  0.
- 35 -
The expressions for γ demonstrate that the optimal
monetary policy under discretion becomes more aggressive
with respect to inflation, when the economy opens up to
migration, trade in goods and capital flow. In contrast, the
expression for x γ demonstrates that the monetary policy
becomes more benign toward fluctuations in
the output-gap when the economy opens up, in every
globalization round.
5. Conclusion
The paper provides a unified analysis of the effects of
international mobility of goods, labor, and finance on
(1) the Phillips curve; (2) the weights of inflation and
output gap in the approximated, utility-based, loss
function; and (3) the optimal interest rate rule under
- 36 -
discretion, within a unified New-Keynesian open
economy framework.
We demonstrate how an endogenously determined
monetary policy, which is guided by the welfare
criterion of the representative household, becomes
more aggressive with regard to inflation fluctuations
but more benign with respect to output-gap
fluctuations, when the economy opens up to in- and
out-migration, trade in goods, and capital flows.
The paper assumes that the flex-price markup is
constant, unaffected by globalization
forces. But there has been some evidence of greater
restraints on domestic prices and
- 37 -
wage growth in sectors more exposed to international
competition, such as textiles and electronics. Chen,
Imbs and Scott (2004) analyzed disaggregated data
for EU manufacturing over the period 1988-2000.
They find that increased openness lowers
prices by reducing markups and by raising
productivity. In response to an increase in
openness, markups show a steep short run decline,
which partly reverse later, while productivity rises in
a manner that increases overtime. If globalization
reduces the markup, our model predicts that this
effect, as by itself, leads to a more forceful antiinflation policy, and lessens the attention given by the
policy maker to the fluctuations in economic activity.
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Finally, as we know, a more frequent price-updating
steepens the tradeoff between inflation and activity.
However, to our knowledge, neither theory nor
empirical evidence exists, in support of any
systematic relationship between globalization and
frequency of price updating.