How has globalisation affected inflation dynamics in the United Kingdom?

Transcription

1 292 Quarerly Bullein 2008 Q3 How ha globaliaion affeced inflaion dynamic in he Unied Kingdom? By Jennifer Greenlade and Sephen Millard of he Bank Srucural Economic Analyi Diviion and Chri Peacock of he Bank Inernaional Finance Diviion. Thi aricle dicue how globaliaion may influence he way inflaion move over he buine cycle in he Unied Kingdom. Globaliaion may do hi by affecing how co repond o change in economic aciviy in he Unied Kingdom or by affecing how inflaion repond o change in co. Some evidence i preened ha ugge globaliaion may have led o an increae in he imporance of impor price relaive o domeic economic aciviy in explaining change in firm co. Bu, once hi ha been aken ino accoun, he repone of inflaion o movemen in co doe no appear o have changed over recen year. Thi ugge i i increaingly imporan o underand wha drive movemen in impor price, paricularly given he rapid rie in global food and energy price over he pa year. Inroducion Alhough inflaion in he long run i ulimaely deermined by domeic moneary policy, globaliaion he progreive inegraion of more counrie ino inernaional rade and financial marke may affec how inflaion move over he buine cycle: in paricular, he repone of inflaion o change in demand relaive o upply. Since he effec of uch change on inflaion i an imporan par of he moneary ranmiion mechanim, i i imporan for cenral bank o underand how globaliaion affec hi. A imple way o look a he hor-run relaionhip beween demand and inflaion i o plo inflaion and unemploymen daa, ince unemploymen will be high when demand i low and vice vera. In he 1980 and early 1990, here wa a able negaive relaionhip beween inflaion and unemploymen, in oher word, lower unemploymen wa aociaed wih higher inflaion. Char 1 how ha here ha been an apparen flaening in hi relaionhip in he Unied Kingdom ince he mid-1990 o ha lower unemploymen ha no generally been aociaed wih higher inflaion. However, uch a picure can be mileading a i doe no allow for change in moneary policy regime, change in he naural rae of unemploymen or exchange rae and impor price developmen. I alo conflae wo diinc, rucural, apec: he link from flucuaion in economic aciviy o firm co of producion and he link from co o inflaion. Globaliaion may affec eiher or boh of hee link. Char 1 Reail price index (RPI) inflaion and LFS unemploymen, preen RPI (percenage change on a year earlier) LFS unemploymen rae (per cen) Thi aricle examine how globaliaion migh have affeced each of hee link. The analyi ue a rucural framework, ince hi beer idenifie which underlying economic mechanim are driving he relaionhip beween economic aciviy and inflaion. The fir ecion explain how globaliaion can have differen effec on he repone of co o change in aciviy and on he repone of inflaion o change in co. The econd ecion look a ome empirical work on he repone of inflaion o change in co. I inveigae wheher impor price, by affecing firm co of producion, help o explain hor-run movemen in inflaion. The reul ugge ha accouning properly for impor price

2 Reearch and analyi How ha globaliaion affeced inflaion dynamic? 293 in firm co lead o a model ha can beer explain UK inflaion and ha failing o do o lead o mileading inference abou he effec of movemen in co on inflaion. Given hi, he aricle alo inveigae wheher he conribuion of impor price ha increaed a he pace of globaliaion ha inenified, in which cae i become even more imporan o accoun properly for he role of impor price in co when examining he link beween demand, co and inflaion. The aricle conclude wih a brief dicuion of he implicaion of hee reul for moneary policy. A framework for hinking abou he effec of globaliaion Given ha firm may only e heir price infrequenly, when hey do ree hem hey will do o wih regard o wha hey expec o happen o heir compeior price unil hey ree heir price again, a well a heir co. Thi idea i capured for he economy a a whole in he rucural New Keyneian Phillip Curve (NKPC) in which inflaion oday depend on expeced fuure inflaion and real marginal co (he co of producing an exra uni of oupu divided by i price): π = βe π +1 + λµ^ (1) where π i he inflaion rae, E π +1 denoe he expecaion formed a ime of inflaion a ime +1, µ^ denoe he deviaion of real marginal co from rend, λ denoe he lope of he NKPC (in oher word, he repone of inflaion o change in co) and β i he rae a which people dicoun he fuure (a number cloe o one). The derivaion of hi relaionhip i decribed in more deail in he annex. In he NKPC, globaliaion can affec inflaion dynamic by affecing he repone of real marginal co, µ^, o economic aciviy, or by affecing he repone of inflaion o movemen in real marginal co, ie he lope of he NKPC. So, o underand he effec of globaliaion on he ranmiion of movemen in demand o movemen in inflaion a key par of he moneary ranmiion mechanim i i imporan o conider each of hee link in he mechanim. In paricular, failing o allow adequaely for he effec of curren economic aciviy on real marginal co, µ^, could lead o mileading inference abou he lope of he NKPC, λ. Effec of globaliaion on he link beween economic aciviy and real marginal co In an open economy uch a he Unied Kingdom, firm impor raw maerial, energy and inermediae good o ue in he producion of oupu. A dicued in he aricle by Bowen and Mayhew on page , hi mean ha movemen in he price of hee impored inpu will have an effec on he level of real marginal co and could have a emporary effec on inflaion, hough he direcion and magniude of hee effec will depend on, for example, he repone of real income expecaion and moneary policy. In addiion, if firm are more able o repond o increae in demand by uing foreign inpu o increae oupu, hen heir real marginal co will repond correpondingly le o increae in domeic demand, which are unlikely o have much effec on hee foreign inpu co. One mechanim i o ue more foreign labour. Two imporan apec of he recen period of globaliaion have been an increae in migraion boh acual migraion and he poenial abiliy of worker o migrae acro border and in ouourcing, hifing par of he producion proce abroad. Thee boh make i eaier for firm o employ foreign labour, eiher a home or abroad. A a reul, hey are boh likely o reduce he repone of real marginal co in UK firm o increae in domeic demand ince he poenial abiliy of firm o employ migran, or o ouource producion o foreign worker, will leen he increae in wage hey would have o pay o arac more labour. In erm of he equaion above, hi would mean ha a given movemen in demand would have a maller effec on µ^. Effec of globaliaion on he repone of inflaion o movemen in real marginal co Given he effec of differen hock on co, a econd queion, hen, i wheher globaliaion ha any effec on he repone of inflaion o change in real marginal co, ie λ in he above equaion. One apec of he recen increae in globaliaion ha been i effec in increaing he compeiion ha domeic firm face. Unforunaely, heory i ambiguou on how increaed compeiion affec he repone of inflaion o movemen in real marginal co. On he one hand, increaed compeiion will make firm more likely o review heir price regularly again heir compeior, making he repone of inflaion o movemen in real marginal co more pronounced. On he oher hand, increaed compeiion may reduce he cope for firm o raie heir price in repone o increae in heir co, for fear of loing marke hare. Thi would ac o reduce he repone of inflaion o movemen in real marginal co. (1) So, wheher increaed compeiion raie or lower he repone of inflaion o movemen in co i an empirical queion. The nex ecion preen ome evidence on hi. Empirical evidence Empirical work baed on he rucural NKPC approach decribed above i relaively recen and i ill evolving. The lieraure ha focued on he link beween movemen in real marginal co and inflaion, ie eimaing λ, bu ha alo highlighed he imporance of correcly meauring marginal co, in paricular, accuraely capuring he role of impor (1) For a deailed heoreical decripion of hee argumen, ee Khan (2004).

3 294 Quarerly Bullein 2008 Q3 price. Thi ecion provide an overview of he curren ae of knowledge. In paricular, i focue on model where firm ubiue beween impored inpu and labour when producing oupu. Recen reearch a he Bank uing hi framework ha concenraed on wo key queion: fir, wheher accouning for movemen in impor price when meauring marginal co ha become more imporan a he pace of globaliaion ha quickened; and econd, once marginal co have been meaured correcly, wheher he lope of he NKPC, λ, ha been affeced by he recen quickening in he pace of globaliaion. Have movemen in impor price become more imporan for explaining movemen in marginal co? Given he framework decribed above, impor price will play an imporan role in explaining hor-run movemen in inflaion if hey have a ignifican effec on firm marginal co. In pracice, marginal co are hard o meaure and any paricular meaure of firm marginal co depend crucially on he aumpion made abou he way firm combine inpu, uch a labour and impored good. A hown in Peacock and Baumann (2008), he weigh of impor price in firm marginal co i broadly relaed o he hare of he value of impor in gro oupu, where he laer i equal o gro domeic produc plu he value of impored good and ervice. Tha hare ha eadily rien in he Unied Kingdom, by around 2 percenage poin ince 1985 (Char 2). Char 2 Impor hare of gro oupu Trend ince Source: ONS and Bank calculaion. Per cen 30 Thi ugge ha movemen in impor price may have become more imporan in explaining movemen in marginal co. Char 3 preen ome furher evidence on hi. I plo wo common meaure of real marginal co: in one ( cloed-economy ), real marginal co are given by real uni labour co; while in he oher ( open-economy ), real marginal co are a weighed combinaion of real uni labour co and real impor price. (1) While boh meaure end o move cloely ogeher, i i clear ha here are a number of Char 3 Cloed-economy and open-economy meaure of UK real marginal co Open-economy model Cloed-economy model Log deviaion from eady ae Source: ONS and Bank calculaion inance of divergence, paricularly in he 1970 and More imporanly for he dicuion here, real uni labour co have been higher relaive o heir average han he open-economy meaure over he pa decade or o. In oher word, accouning for movemen in impor price give a differen picure of recen movemen in marginal co. A number of udie eimae he rucural NKPC decribed above. They find ha he open-economy meaure of real marginal co (ha i, including impor price) provide a ignificanly beer fi for UK inflaion han he cloed-economy meaure (eg Balakrihnan and López-Salido (2002); Baini e al (2005)). More recen work ha buil upon hi rand of he empirical lieraure by employing more robu eimaion echnique and lenghening he ample period (eg Kurmann (2007) and Peacock and Baumann (2008)). Ha he lope of he NKPC changed during he recen period of increaing globaliaion? Peacock and Baumann (2008) pecifically examine he queion of wheher he increaing pace of globaliaion in recen year ha led o a change in he lope of he NKPC, λ. To anwer hi queion hey demonrae he imporance of correcly meauring he effec of impor price on marginal co by eimaing he lope of he NKPC uing he cloed and open-economy meaure of marginal co hown in Char 3. Char 4 how no relaionhip beween real marginal co and inflaion when he cloed-economy meaure i ued: he poin appear o be caered around a horizonal line. By conra, Char 5 how ha meaure of marginal co ha appropriaely include he impac from impor price reveal he expeced poiive link beween co and inflaion: he poin (1) Under cerain aumpion, pel ou in he annex, real uni labour co will be equal o real marginal co. Under alernaive aumpion, he open-economy meaure ued here will be equal o real marginal co. Thi meaure i baed upon a calibraion of he model in Peacock and Baumann (2008), which i alo he benchmark calibraion ued in Balakrihnan and López-Salido (2002). Boh meaure are ploed a he log deviaion from eady ae, which are e o heir ample average.

4 Reearch and analyi How ha globaliaion affeced inflaion dynamic? 295 Char 4 Inflaion and real marginal co: cloed-economy model Real marginal co (log deviaion from eady ae) Inflaion (log deviaion from eady ae) Source: ONS and Bank calculaion. Char 5 Inflaion and real marginal co: open-economy model Inflaion (log deviaion from eady ae) Source: ONS and Bank calculaion lie around an upward-loping line, giving a poiive value for λ. So, failure o meaure real marginal co correcly could give a mileading view of wheher he relaionhip beween inflaion and firm co had changed over ime. The change in he repone of real marginal co o hock, becaue impored inpu have become more imporan, would be incorrecly aribued o a change in he lope of he NKPC. Thee iue are paricularly relevan currenly given he rapid rie in global food and energy price over he pa year. Uing real uni labour co o proxy real marginal co would ugge a more benign near-erm oulook for inflaion han ha implied by a meaure of real marginal co ha appropriaely ake impor price developmen ino conideraion. Real marginal co (log deviaion from eady ae) Peacock and Baumann (2008) ugge ha once impor price are included in he meaure of marginal co, here ha been no ignifican change in λ, he lope of he NKPC, ince he mid So he recen quickening in he pace of globaliaion doe no eem o have affeced he relaionhip beween marginal co and inflaion. A dicued on page 293, heory i ambiguou abou wheher globaliaion migh affec he relaionhip beween co and inflaion o hi reul i no ha urpriing. In addiion, i i in line wih he reul of Groen and Mumaz (2008) who ue a differen mehodology o eimae how he rucural NKPC ha varied over ime, finding ha he lope ha no changed over he period hey conider. In ummary herefore, wih he co of impor now forming a larger par of oal co, i would eem likely ha movemen in impor price now play a more imporan role in explaining hor-erm movemen in UK inflaion han in he pa. And once hee movemen are accouned for, hi aricle find lile evidence ha he lope of he rucural NKPC ha changed ince he mid Concluion I i imporan for a cenral bank o underand wha globaliaion mean for inflaion and he moneary ranmiion mechanim. The rucural NKPC model oulined in hi aricle how ha o underand he effec of globaliaion on he moneary ranmiion mechanim i i neceary o conider boh he impac of globaliaion on he repone of real marginal co o movemen in demand and he repone of inflaion o movemen in real marginal co. Globaliaion increae he abiliy of firm o ubiue ou of domeic inpu and ino foreign inpu, reducing he reponivene of real marginal co o movemen in domeic economic aciviy. Alhough heory i unclear abou how globaliaion may affec he repone of inflaion o real marginal co, he evidence preened in hi aricle ugge ha he repone ha no changed markedly during he recen period of globaliaion. Bu, i i crucially imporan o meaure real marginal co appropriaely in paricular, accouning for impored inpu price a he empirical reul preened in hi aricle ugge ha failing o do o could lead o he miaken concluion ha he repone of inflaion o movemen in real marginal co had changed. Moreover, here i evidence ha impor price have become a more imporan componen of real marginal co over recen year. Thi make i imporan o underand wha drive movemen in impor price, paricularly given he rapid rie in global food and energy price over he pa year.

5 296 Quarerly Bullein 2008 Q3 Annex The New Keyneian Phillip Curve (NKPC) Thi annex how how o derive he NKPC. The inuiion i ha when a firm come o e i price, i will do o wih regard o i co and how i expec he price of i compeior o evolve over he period unil i once again ree i own price. Fir, uppoe ha he economy coni of monopoliically compeiive firm. Following Calvo (1983), uppoe ha each period a proporion 1 ξ of firm e heir price. When eing heir price, heir aim i o maximie heir expeced profi over he ime ha hey expec o pa unil hey can ree heir price. Their expeced profi will be given by: E P βξ µ P+ y P P j, j, ( ) + + = 0 + (A1) where β i he dicoun rae, P j i he price e by firm j (able o change i price), P i he aggregae price level, µ i real marginal co, y i aggregae demand and η i he elaiciy of demand for firm j good. The fir-order condiion for a price-changing firm will be given by: E ( ) = 0 βξ ( 1 η 1 µ + P P The aggregae price level will be given by ξ 1 ξ = 1 j, P P P (A2) (A3) Combining equaion (A2) and (A3) and aking a fir-order Taylor erie expanion implie he NKPC: ( 1 ξ βξ π = βeπ + )( 1 ) + 1 ˆ µ ξ = βe π + λµ ˆ + 1 (A4) where π i he inflaion rae, µ^ denoe he log deviaion of real marginal co from rend and λ denoe he lope of he NKPC. A can be een, inflaion depend on real marginal co reflecing he fac ha firm wan o e heir price a a mark-up over co and fuure expeced inflaion reflecing he fac ha firm are forward looking and realie ha heir relaive price may change during he ime ha heir price remain fixed. Equaion (A4) alo make clear ha, a lea according o hi model, he repone of inflaion o change in real marginal co will depend only on he dicoun rae and how ofen firm ree heir price: he more ofen hey ree heir price (lower ξ), he more rongly inflaion reac o a given movemen in real marginal co. (1) y ) P η + + P P j, j, + + η = 0 The key poin of he aricle i ha he repone of inflaion o hock will depend on boh he repone of inflaion o real marginal co and he repone of real marginal co o he hock. To ae he repone of real marginal co o hock implie he need for a good meaure of real marginal co. I i relaively raighforward o how ha if oupu i produced according o a Cobb-Dougla producion funcion, ie y = h α x 1-α where h i labour inpu and x i a compoie non-labour inpu, hen real marginal co will be equal o he labour hare (real uni labour co) defined a Wh Py where W i he nominal wage. Thi i he cloed-economy meaure referred o in he main ex. For a mall open economy uch a he Unied Kingdom, a key componen of co will be he co of impored raw maerial, energy and inermediae good, and i i likely ha he producion funcion combining hee wih labour i no Cobb-Dougla. So, uppoe ha firm ue labour and impored inermediae, M, o produce oupu according o he conan reurn o cale, conan elaiciy of ubiuion, producion funcion: 1 1 y = αmm σ + αhh σ 1 1 σ 1 σ In hi cae, real marginal co will be given by: µ = α + M Wh 1 α h Py σ P M W 1 σ (A5) where P M i he price of impored inermediae in domeic currency and W i he nominal wage. In erm of deviaion from eady ae: ˆ µ = µ ( 1 σ )( P ˆ W ˆ )+ ˆ M µ (A6) where µ^ i he percenage deviaion of real marginal co from i eady-ae value, µ, ^ i he percenage deviaion of real uni labour co from i eady-ae value,, σ i he elaiciy of ubiuion beween labour and impored inermediae, P^M i he percenage deviaion of he price of impored inermediae from eady ae and W^ i he percenage deviaion of wage from heir eady ae. Thi i he meaure referred o a he open-economy meaure of real marginal co in he main ex. According o equaion (A6), he effec of a given hock, uch a a demand hock, on real marginal co will depend on he effec of he hock on he price of impored inermediae (1) A explained in he main ex, differen model imply ha hi repone could alo depend on he degree of compeiion in he economy.

6 Reearch and analyi How ha globaliaion affeced inflaion dynamic? 297 relaive o wage in addiion o i effec on real uni labour co, ogeher wih he degree of ubiuabiliy beween labour and impored inermediae and eady-ae real marginal co. To he exen ha globaliaion ha increaed he degree of ubiuabiliy beween labour and impored inermediae, ie σ, equaion (A6) would ugge ha he repone of real marginal co o a given hock hould have fallen. Similarly, if globaliaion ha reduced he eady-ae mark-up ha i, increaed eady-ae real marginal co (i invere), µ, hen equaion (A6) would again ugge ha he repone of real marginal co o a given hock hould have fallen (given σ ha been eimaed o be greaer han one in he lieraure). Noe ha if real uni labour co were ued o proxy real marginal co, any change in he repone of real marginal co o hock, becaue for example impored inpu have become more imporan, would be incorrecly aribued o a change in he repone of inflaion o change in real marginal co, he poin made in he main ex.

7 298 Quarerly Bullein 2008 Q3 Reference Balakrihnan, R and López-Salido, D (2002), Underanding UK inflaion: he role of openne, Bank of England Working Paper no Baini, N, Jackon, B and Nickell, S (2005), An open-economy New Keyneian Phillip Curve for he UK, Journal of Moneary Economic, Vol. 52, page 1, Calvo, G A (1983), Saggered conrac in a uiliy-maximiing framework, Journal of Moneary Economic, Vol. 12, page Khan, H (2004), Price-eing behaviour, compeiion, and mark-up hock in he New Keyneian model, Bank of England Working Paper no Kurmann, A (2007), VAR-baed eimaion of Euler equaion wih an applicaion o New Keyneian pricing, Journal of Economic Dynamic and Conrol, Vol. 31, page Peacock, C and Baumann, U (2008), Globaliaion, impor price and inflaion dynamic, Bank of England Working Paper, forhcoming. Groen, J J J and Mumaz, H (2008), Inveigaing he rucural abiliy of he Phillip curve relaionhip, Bank of England Working Paper no. 350.