Can Domestic Policies Influence Inflation?

November 1, 2007

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Format: Chicago

Ashoka Mody, and Franziska L Ohnsorge. Can Domestic Policies Influence Inflation?, (USA: International Monetary Fund, 2007) accessed November 12, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

Globalization operates not only by reducing domestic pressures on inflation but also by reducing the scope of domestic authorities to influence the pace of inflation. First, as markets are integrated, the common, cross-border sources of inflation increase, reducing the extent of domestically-generated inflation. Based on a methodology identifying common time and sectoral trends, we find this to be especially the case in the countries of the eurozone, with their longer histories of product market integration. Second, even the domestically-generated component of inflation may be difficult to manipulate. Policies act, especially in the shortrun, through managing domestic demand. But the relationship between domestic demand (proxied by the output gap and unit labor cost growth) and inflation has been weak, constrained in part by trade openness. Moreover, the domestic component of inflation contains a country-specific international catch-up process that generates price equalization across countries. The evidence is that catch-up has accelerated with increasing market integration. Thus, for the eurozone economies, there may be limits on the use of fiscal and labor market policies to contain inflation. The new member states may not have policy leverage to meet the Maastricht inflation limit necessary for entering the eurozone. Casestudies show that fiscal consolidation needed to comply with the inflation criterion can be large and sustained only briefly to get under the Maastricht wire.

Subject: Foreign exchange, Inflation, Labor, Labor costs, Nominal effective exchange rate, Output gap, Prices, Production, Taxes, Value-added tax

Keywords: Business cycle, Catch-up process, Convergence effects in the eurozone, EMU accession, Euro adoption, Europe, Eurozone country, Eurozone economy, Eurozone sample, Exchange rate, Fiscal policy, Globalization, Inflation, Inflation criterion, Inflation increase, Inflation term, Labor cost movement, Labor costs, Maastricht criterion, Maastricht inflation criterion, Money market, Nominal effective exchange rate, Output gap, Phillips curve, Price convergence, Rate of inflation, Value-added tax, WP

Publication Details

Pages:

36
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2007/257
Stock No:

WPIEA2007257
ISBN:

9781451868203
ISSN:

1018-5941

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