Working Paper: CEPR ID: DP4895
Authors: Assaf Razin; Prakash Loungani
Abstract: The paper analyses how globalization forces induce monetary authorities, guided in their policies by the welfare criterion of a representative household, to put greater emphasis on reducing the inflation rate than on narrowing the output gaps. We demonstrate that the marginal rate of substitution between the output gap and the inflation (at a constant value of the utility-based loss function) rises when the economy is opening up to international trade in goods, and is integrated to the world capital markets. We associate the marginal rate of substitution with the sacrifice ratio, and provide evidence on trade and capital openness effects on inflation, through the efficiency channel.
Keywords: capital-account openness; trade openness; utility-based loss function
JEL Codes: E50; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Globalization (F60) | Central Banks prioritize inflation reduction (E52) |
| Increased trade and capital markets opening (F69) | Marginal rate of substitution between inflation and output gap increases (E31) |
| Increased marginal rate of substitution (D11) | Higher sacrifice ratio (D64) |
| Globalization (F60) | Sacrifice ratio reduction (C79) |
| Higher sacrifice ratio (D64) | Central Banks become more conservative (E58) |