Working Paper: NBER ID: w11641
Authors: Assaf Razin; Prakash Loungani
Abstract: We demonstrate how capital account and trade account liberalizations help reduce inefficiencies associated with the fluctuations in the output gap, relative to the inefficiencies associated with the fluctuations in inflation. With capital account liberalization the representative household is able to smooth fluctuations in consumption, and thus becomes relatively insensitive to fluctuations in the output gap. With trade liberalization the economy tends to specialize in production but not in consumption. The correlation between fluctuations in the output gap and aggregate consumption is therefore weakened by trade openness; hence a smaller weight on the output gap in the utility-based loss function, compared to the closed economy situations.A key implication of the theory is that globalization forces could induce monetary authorities, to put a greater emphasis on reducing the inflation rate than on narrowing the output gaps. We provide a re- interpretation of the evidence on the effect of openness on the sacrifice ratio which supports the prediction of the theory.
Keywords: globalization; inflation; output gap; trade liberalization; monetary policy
JEL Codes: E3; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital account liberalization (F32) | households smooth consumption fluctuations (D15) |
| households smooth consumption fluctuations (D15) | reduced sensitivity to output gap fluctuations (E39) |
| trade liberalization (F13) | specialization in production but not in consumption (F12) |
| specialization in production but not in consumption (F12) | weaker correlation between output gap fluctuations and aggregate consumption (E20) |
| weaker correlation between output gap fluctuations and aggregate consumption (E20) | smaller weight on output gap in utility-based loss function (D11) |
| globalization (F60) | reduced sensitivity to output gap fluctuations (E39) |
| trade liberalization (F13) | altered utility-based loss function (D11) |
| increased openness (O36) | lower prices (P22) |
| increased openness (O36) | higher productivity (O49) |
| lower prices and higher productivity (O49) | affects inflation-output tradeoff (E31) |
| globalization (F60) | shift in central bank focus towards inflation control (E52) |
| shift in central bank focus towards inflation control (E52) | increased sacrifice ratio (H56) |