Globalization, the output–inflation tradeoff and inflation

This paper provides comprehensive evidence on the relation between inflation and globalization, defined here as trade and financial openness, using a large cross-section of 91 countries over the period 1985–2004. We establish two main empirical regularities: both higher trade and financial openness (i) reduce central banks’ inflation bias, yielding lower average inflation and (ii) are associated with a larger output–inflation tradeoff. This evidence is at odds with the standard Barro–Gordon framework, which would require globalization to have a negative effect on the output–inflation tradeoff to yield lower equilibrium inflation, but it is consistent with a recent strand of new Keynesian models emphasizing the role of imperfect competition and nominal rigidities. Our findings also support the relevance of the time-inconsistency hypothesis, which underlies the theoretical models predicting a relation between globalization and inflation. For the OECD subsample, however, we do not find an effect of openness on inflation (the output–inflation tradeoff), suggesting that these countries have created an institutional framework for central banks that eliminates distortions due to the time-inconsistency problem.