Working Paper: NBER ID: w3936
Authors: David Romer
Abstract: This paper points out and tests a straight forward but previously unnoticed prediction of models in which the absence of precommitment in monetary policy leads to excessive inflation. Because unanticipated monetary expansion leads to real exchange rate depreciation, and because the harms of real depreciation are greater in more open economies, the benefits of surprise expansion are decreasing in the degree of openness. Thus, under discretionary policy-making, money growth and inflation will be lower in more open economies. After presenting a simple theoretical model demonstrating this prediction of the theory, the paper examines the link between openness and inflation using cross-country data. The data reveal a strong negative link between openness and inflation.
Keywords: Openness; Inflation; Monetary Policy
JEL Codes: E42; E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of precommitment in monetary policy (E60) | inefficiently high inflation (E31) |
| surprise monetary expansion (E59) | real exchange rate depreciation (F31) |
| increased openness (O36) | reduced incentives for surprise monetary expansion (E52) |
| alternative explanations for observed relationship do not hold (C20) | reinforces dynamic inconsistency problem mitigation (D15) |
| increased openness (O36) | lower equilibrium inflation rates (E31) |
| increased openness (O36) | lower inflation (E31) |