How Has Globalization Affected Inflation?

market economies has remained remarkably subdued over the past two years despite a significant rise in commodity prices, strong growth, and a broadly accommodating monetary policy stance in the major currency areas. Is this situation sustainable or does it foreshadow unwelcome inflation surprises in the near future? Some analysts have argued that low and stable inflation reflects more intense global competition, which prevents firms from raising prices and puts downward pressures on wages in many sectors.1 If so, and given that lower-cost producers in emerging markets and developing countries will continue to integrate into the global trading system, these forces are likely to ensure low inflation in the foreseeable future, reminiscent of the secular deflation associated with broad productivity increases during the classical gold standard in the late nineteenth century. However, such views are not universally shared. Other analysts have offered alternative explanations for the recent inflation performance, including improved monetary policy credibility, broad productivity gains of uncertain duration, or cyclical conditions.2 Looking forward, the issue of whether or not globalization has indeed been a factor driving recent inflation behavior has important implications for the conduct of monetary policy. For example, if it could be established that the tailwind from declining prices of many internationally traded goods matters for inflation and is likely to continue, monetary policy would likely have to be less restrictive to meet a certain inflation target than it would have to be otherwise. If the magnitudes and duration of the tailwind were overestimated, however, monetary policy may risk being too expansionary. Against this background, this chapter explores the relationship between globalization and inflation, using both aggregate and sectoral analysis. The chapter seeks to address the following questions. • How has globalization affected inflation over the past 15 years or so? • How has globalization affected prices and costs at the sectoral level? • Will globalization put downward pressure on inflation in the future, and, if so, what are the implications for monetary policy? Two points should be noted at the outset. • The chapter will take the now firmly entrenched goals of low and stable inflation as given. • As usual, one needs to be specific in delineating the scope of globalization. For the purposes of the chapter, globalization is defined broadly as the acceleration in the pace of growth of international trade in goods, services, and financial assets relative to the rate of growth in domestic trade.3 At the global level, this encompasses the growth spurts in key emerging market economies—notably China and, to a lesser extent, India. Globalization has also overlapped with economic and financial deregulation in many countries and with the information technology revolution. While an attempt is made to distinguish between these phenomena, this is often difficult to accomplish in practice.