International Trade and the Connection Between Excess Demand and Inflation by. Albert S. Dexter Maurice D. Levi and Barrie R. Nault* October 10, 2002

Transcription

1 Inernaional Trade and he Connecion Beween Excess Demand and Inflaion by Alber S. Dexer Maurice D. Levi and Barrie R. Naul* Ocober 10, 2002 * Dexer and Levi: Professors of Commerce and Business Adminisraion, Universiy of Briish Columbia; Naul: Professor of Managemen, Universiy of Calgary. Helpful commens and advice were received from an Associae Edior and wo anonymous referees of his Review. Financial suppor from he Social Sciences and Humaniies Research Council of Canada is graefully acknowledged. All views expressed and any errors ha may remain are hose of he auhors. Keywords: Inflaion, Phillips Curve, Capaciy Uilizaion, Globalizaion. Please do no quoe or cie wihou he auhors permission. Commens are welcome. Copyrigh 2002 by Alber S. Dexer, Maurice D. Levi and Barrie R. Naul. All righs reserved.

2 Absrac This paper demonsraes ha globalizaion, aking he form of a higher impor componen of consumpion and a larger expor componen of GDP, is he cause of he apparen breakdown in he relaionship beween excess demand and inflaion. Wihin a parsimonious empirical framework, we show ha increasing openness of he U.S. economy is all ha is needed o reesablish he relaionship beween inflaion and capaciy uilizaion. We also show ha inernaional rade has a significan separae influence on inflaion, and is imporan for idenifying a Phillips curve relaionship beween unemploymen and inflaion. 2

3 I. Inroducion In a closed economic environmen i is generally believed ha inflaionary pressures increase as excess demand builds in he economy. For example, Rober Gordon (1989a) has shown ha in he Unied Saes capaciy uilizaion wihin he economy was been a good, posiive predicor of inflaion from he mid-1950s o he lae 1980s. However, as Kenneh Emery and Chih-Ping Chang (1997) have shown, he inflaion-capaciy link ha exised before he early 1980s has broken down. Several hypoheses for his breakdown have been pu forward. These include produciviy advances due o echnological change, a general shif from goods o relaively sicky-priced services, energy price variaions which have added noise, changes in money growh, and increases in inernaional rade (Carol Corrado and Joe Maey, 1997; Mary Finn, 1996). In his paper, we focus on he effecs of inernaional rade on he relaionship beween excess demand pressures and inflaion. The possibiliy ha inernaional rade is responsible for he apparen breakdown of he relaionship beween excess demand and inflaion is suggesed in he analyses of Phillips curve relaionships sudied by Rober Gordon (1998) and Rober Rich and Donald Rissmiller (2000). For example, in a sudy of supply shocks and inflaion, Gordon found impor prices relaive o overall prices are an imporan par of he explanaion of he Goldilocks economy of he 1990s ha is, an economy wih simulaneously low inflaion and low unemploymen. Similarly, using he difference beween he percenage change in impor prices and he percenage change in core CPI, Rich and Rissmiller concluded ha impor prices are a key influence on he recen behavior of inflaion. In addiion Geoffrey Tooell (1998) finds ha large increases in non-oil impor price inflaion have had a significan affec on overall US inflaion, alhough decreases do no. We ake a broader view of inernaional rade ha considers he role of he quaniies of boh impors and expors raher han jus he price of impors: ceeris paribus, greaer availabiliy of goods hrough rade subdues inflaion. Our approach also allows for he 3

4 indirec impac of compeiion from impored goods on he prices of domesically produced goods, as well as he direc impac hrough inclusion in he CPI. By including he real impor share of consumpion and real expor share of producion, we explain he apparen recen absence of a link beween excess demand pressures and inflaion. We find ha accouning for inernaional rade re-esablishes he hisorically srong relaionship beween capaciy uilizaion and inflaion. Furhermore, accouning for inernaional rade srenghens he Phillips curve relaionship beween unemploymen and inflaion. In addiion, we show ha rade volumes hemselves are a significan influence on inflaion, in addiion o he excess demand pressures from capaciy or unemploymen. These resuls are robus o differen measures of rade. II. Openness, Trade and Inflaion The relaionship beween domesic marke pressure and inflaion depends on openness o inernaional rade. Specifically, he availabiliy of impors can affec domesic inflaion direcly via he prices of hese impors included in he price index, and indirecly hrough compeiion wih domesic goods and services. Expors affec supplies of producs available o domesic consumers, and hence prices. Tha is, inernaional rade serves like an open door, such ha pressures wihin he economy are miigaed by he flows of producs ino and ou of ha door. Consideraion of openness suggess ha jus as he effecs of effors o change pressure in a room will be miigaed by an open door, so oo are effecs of domesic capaciy or unemploymen pressures on inflaion. The poenial relevance of openness is suggesed by he shif in quaniies of impors and expors in he early 1980s ha coincides wih he ime when he link beween inflaion and capaciy uilizaion breaks down (Emery and Chang, 1997): he door opened wider in he early 1980s. For example, from 1967 hrough 1981 impors only grew from 9% o 11% of personal consumpion expendiures, whereas from 1982 hrough he firs quarer of 1999 impors more han doubled, expanding from 11% o 24% of consumpion. 4

5 Growh in expors was more similar in he wo sub-periods, growing from 4% of GDP in 1967 o 7% by he end of 1981, and hen o 13% of GDP by he firs quarer of The more recen period, ha which begins in he early 1980's, has shown a shif in he US from a more isolaed, independen economy o an increasingly open one. Accouning for inernaional rade may also be an elemen of he difficuly finding a sable Phillips curve relaionship (Rober Gordon, 1989b). Because inflaion is influenced by rade as well as by unemploymen, a failure o allow for he imporance of rade for inflaion may confound he measured Phillips curve relaionship. One approach o explaining inflaion in an open economy is o use foreign excess demand pressures as a predicor of inflaion in he prices of US impors, and hen include impor inflaion in he predicion of US inflaion. However, as Carol Corrado and Joe Maey (1997) and Tooell (1998) show, here is lile evidence ha foreign capaciy uilizaion influences US inflaion. Consequenly, if i is o play a role, he effec of US impor price inflaion mus come a leas in par hrough he effecs of increased supply and consequen downward price pressure on domesic goods. Similarly, if expors are o play a role, i is hrough reduced supply o domesic buyers, and hence in he increased compeiion for ha supply. In wha follows, we consider his possible impac of openness using relaive rade volume measures, boh for he capaciy-inflaion relaionship and for he Phillips curve. The srucural advanage of basing inflaion on he available quaniies of raded goods and services raher han on values or prices is wofold. Firs, we avoid having prices on boh sides of he esimaion equaion. Second, while higher impor prices raise inflaion, higher impor quaniies reduce inflaion. As a resul, using values of impors involves wo offseing influences. In addiion, while a higher quaniy of expors could increase inflaion hrough lower domesic availabiliy, here is no impac of expor prices on he counry s CPI. 5

6 III. Daa Descripion In our analysis, we measure inflaion as he difference of he logarihms of he CPI from he quarerly levels of he CPI for 1967:1 o 1999:1. The CPI, as wih all he daa used, is seasonally adjused and obained from he Federal Reserve Economic Daabase (FRED), available from he Federal Reserve Bank of S. Louis. Some of he work on he link beween excess demand pressures and inflaion has focused on oher measures of inflaion. For example, Corrado and Maey (1997) use core CPI measured in erms of acceleraions, Rich and Rissmiller (2000) use core CPI inflaion, and Gordon (1998) uses he GDP and personal consumpion expendiure (PCE) deflaors. However, he primary difficuly has been in explaining inflaion in he CPI, which is he focus of his sudy. We measure excess demand pressures wo ways. Firs, capaciy uilizaion is measured by he Federal Reserve Board's oal capaciy uilizaion rae. Our quarerly measure is ha of he las monh of each quarer, maching he quarer-end o quarer-end CPI inflaion. Second, unemploymen is measured as deviaions in he civilian unemploymen rae from a 16-quarer moving average. This allows he normal unemploymen rae our 16- quarer moving average o be ime-varying. Our quarerly measure for he civilian unemploymen rae is he average over he hree monhs of each calendar quarer. To allow for he imporance of availabiliy of impors for he relaionship beween excess demand and inflaion we ake he raio of real impors o real personal consumpion expendiures. To allow for he impac of expors we ake he raio of real expors o real GDP. Boh of hese raios have been increasing over ime, and more imporanly, capure boh he direc and indirec effecs of rade on inflaion: we expec a negaive inflaionary impac of impor growh and a posiive impac of expor growh. Available daa from he Bureau of Economic Analysis, Deparmen of Commerce, for real impors and expors are in chained 1992 dollars, as are real personal consumpion 6

7 expendiures and real GDP. As has been indicaed by Whelan (2000), he use of chainaggregaed daa can significanly influence empirical relaionships. The problem is paricularly acue for capial goods for which relaive prices have declined over ime. 1 Therefore, we also repor resuls for real expor and impor raios of non-durable goods and services where he problem should be less severe. We include a supply shock as does Gordon (1998) and Rich and Rissmiller (2000). This is measured as he raio of he price of energy from he energy componen of he CPI relaive o he overall CPI. All daa is seasonally adjused. IV. The Capaciy Uilizaion Inflaion Relaionship In order o evaluae he role of inernaional rade we firs measure he impac of oal capaciy uilizaion on inflaion, wihou allowing for he effecs of rade. We hen add he rade variables o see wheher hese help unravel he effecs of capaciy uilizaion on inflaion and o see wheher hese variables hemselves are significan. The benchmark agains which inernaional rade effecs are measured includes, in addiion o oal capaciy uilizaion, he lagged inflaion rae from differences in logarihms and our energy supply shock variable. This makes equaion (1) below essenially he same as he one used by Gordon (1998) and Rich and Rissmiller (2000). Tha is, we firs esimae e P dlnp = dlnp d ln( ) + 3 lnd -1 +, (1) P and hen we esimae e P M dlnp = dlnp d ln( ) + 3 lnd ln P C X + 5 ln + (2) G where 1 We hank one of he referees for bringing his o our aenion. 7

8 P = Overall CPI e P = Energy price componen of he CPI D = Toal indusry percen capaciy uilizaion M = Real impors of goods and services C = Real consumpion expendiures X = Real expors of goods and services G = Real GDP, chained 1992 dollars 2 Inflaion is aken as he firs difference in he log of he CPI, and pu ino percenages by muliplying by 100. The supply shock is measured as he rae of change of he relaive price of energy o he overall CPI, ha is, he firs difference of he log of he raio of he energy componen of he CPI o he overall CPI. The rade variables are logs of he raios of real impors o real personal consumpion and of real expors o real GDP. The excess demand variable is he log of oal capaciy uilizaion, lagged one period. The Augmened Dickey-Fuller uni roo es rejecs he presence of a uni roo on all relevan righ hand variables ha is, hose variables no differenced already. The presence of a uni roo is rejeced a he 1% level for our capaciy uilizaion and expors variable, and a he 5% level for our impors variable. Boh equaions (1) and (2) are esimaed over he wo sub-periods, 1967:1-1981:4, and 1982:1-1999:1, as well as over he enire sample period. 3 Our principal purpose is o see wheher capaciy uilizaion has a more significan impac afer allowing for inernaional rade, especially since he early 1980's. In addiion, we expec 4 < 0 on he grounds ha more impors reduce inflaionary pressures: i is as if US capaciy becomes less relevan when he door is open wider. We also expec 5 > 0, reflecing he added inflaionary impac of expored goods and services no being available for US consumers o buy. (Table 1 abou here) 2 As menioned earlier, real impors and expors are also measured wihou including durables o miigae he problem of using chain-aggregaed daa. 3 The srucural break a he end of 1981, menioned in he lieraure cied earlier, is confirmed by he Chow Breakpoin Tes. The null hypohesis of no breakpoin is rejeced a he level of significance for capaciy uilizaion, and a he level for unemploymen. 8

9 Resuls for he enire sample period are summarized in Table 1. Comparison of he firs column of Table 1 wih he second column shows he effec of including inernaional rade when accouning for inflaion. Specifically, he inclusion of rade increases he size and significance of capaciy uilizaion. The supply shock is marginally significan when rade is included. Boh rade variables are significan and carry he expeced sign. We find ha increasing real impors is, ceeris paribus, associaed wih lower inflaion significan a he 1% level. Also as expeced, increasing real expors, which means ceeris paribus fewer goods and services available for Americans o buy, has a posiive impac on inflaion. This is also significan a he 1% level. Even hough boh rade variables have an upward rend, we find one wih a negaive impac and he oher wih a posiive impac, indicaing he effecs are no saisical arifacs. As well as being significan hemselves and conribuing o he significance of capaciy uilizaion, he rade variables improve he overall explanaion of inflaion as measured by he adjused R 2. The hird column of Table 1 shows ha capaciy uilizaion remains significan when durable goods impors and expors, for which chain-aggregaion may be more problemaic, are excluded. However, while impors remain significan when durable goods are excluded, expors are no longer significan. The firs wo columns of Table 2 show he insignificance of he impac of capaciy uilizaion ha has been observed for he period since he early 1980's as compared o he earlier period. We also see from he R 2 for column 2 ha inflaion is poorly explained even when his explanaion includes he ineria from lagged inflaion and he supply shock from he relaive increases in prices of energy. Indeed, he only significan variable in column 2 is he supply shock. Comparison of he hird and fourh columns of Table 2 wih he firs and second columns shows he imporance of including he rade variables for boh sub-periods, where rade measures are based on chain-aggregaed daa. Capaciy uilizaion is significan a he 1% level in boh sub-periods. The supply shock is significan a he 1% level for he laer period relaively higher energy prices conribue o inflaion. Expors have a significan posiive relaionship wih inflaion in he earlier 9

10 period, and impors have a significan negaive relaionship wih inflaion in he laer period. While no saisically significan, impors in he firs period and expors in he second period also have he expeced signs. Comparing he adjused R 2 s in he second and fourh columns versus he firs and second columns shows ha inclusion of he rade variables is paricularly imporan in he laer sub-period. The final wo columns of Table 2 show ha excluding durable impors and expors does no change he influence of capaciy uilizaion: i remains significan a he one-percen level in boh sub-periods. Comparing he remaining pars of he final column wih column four shows ha any problems inroduced by chain-aggregaion in he durable goods have no subsanially influenced he resuls. (Table 2 abou here) V. The Phillips Curve and Inernaional Trade Two excess demand variables have been employed in previous research in his area, such as he work by Gordon (1998) and Rich and Rissmiller (2000), namely capaciy uilizaion as above, and he rae of unemploymen. This laer measure, which corresponds more direcly o he radiional Phillips curve, means rewriing equaions (1) and (2) as: e P dlnp = dlnp d ln( ) + 3 ln U +, (3) P and e P M dlnp = dlnp d ln( ) + 3 U + 4 ln P C X + 5 ln + (4) G where U is deviaions in he civilian unemploymen rae from a 16-quarer moving average. The deviaions from he moving average is used o allow for ime variaion in he normal rae of unemploymen, and because he unemploymen rae has a uni roo. The augmened Dickey-Fuller uni roo es rejecs he presence of a uni roo in our chosen unemploymen variable a he 1% level. 10

11 Table 3 shows he resuls from esimaing equaions (3) and (4) for he enire period, o , noing ha use of he 16-quarer moving average in calculaing deviaions from he civilian unemploymen rae reduced he number of observaions relaive o our esimaions using capaciy uilizaion. The lef-hand column shows he Phillips curve wihou accouning for inernaional rade, and shows ha unemploymen is insignifican, as is he supply shock. The second column shows ha adding he rade variables makes unemploymen significan a he 1% level, and he supply shock becomes significan a he 5% level. Mos imporanly for he argumens made in his paper, he wo rade variables are boh saisically significan a he 1% level and wih he expeced signs. Increasing impors keeps inflaion down, and increasing expors, by ceeris paribus reducing he supplies of goods in he domesic marke, raises he rae of inflaion. We also noe an improvemen in he adjused R 2 from adding he rade variables o he Phillips curve equaion. (Table 3 abou here) Table 4 shows he difference beween he earlier and laer sub-periods. Comparison of column 1 wih column 2 shows ha inflaion in he laer period is harder o explain, cerainly when he rade variables are excluded. We see for example ha he R 2 is 0.60 in he firs period and 0.13 in he second period. Unemploymen is only significan in he firs sub-period when we ignore he influence of rade. In he laer period only he supply shock is significan, as we migh expec. However, when he rade variables are included we find unemploymen significan in boh periods: i is significan a he 1% level in he laer period, and a he 5% level in he earlier period. The supply shock is also significan in he laer period, a he 1% level. Furhermore, we find a significan posiive effec of expors in boh periods and a significan negaive effec of impors in he second period: boh second-period rade variables are significan a he 1% level. We also noe ha he overall fi is higher in boh sub-periods, wih he R 2 for he firs period a respecable In he second period, he inernaional rade variables raise he fracion of inflaion ha 11

12 can be explained by approximaely hree imes, from 0.13 o Inernaional rade appears o play an imporan role in he esimaion of he Phillips curve. (Table 4 abou here) VI. Conclusion The resuls we have shown in his shor paper provide comfor on a leas wo frons. Firs, he workings of he economy have no changed: inflaion sill appears o be associaed wih excess demand pressures, as economiss generally believe. Second, he measure of capaciy uilizaion "oal indusry capaciy uilizaion" remains useful, somehing ha had been in quesion in ligh of he poor resuls of hose sudying inflaion who have no allowed for he presence of inernaional rade (see, for example, Rose McElhaan (1985), Mahew Shapiro (1989), and Sephen Cecchei (1995)). Third, inernaional rade plays a role in i s own righ, playing a significan role iself, as well as helping isolae he underlying relaionship beween excess demand and inflaion. Finally, allowance for he influence of inernaional rade is necessary for he clear and consisen idenificaion of he Philips curve. I would appear ha he Phillips curve relaionship has been obscured by he changes ha have occurred in he openness of he U.S. economy o inernaional rade. 12

13 Bibliography Cecchei, Sephen G., "Inflaion Indicaors and Inflaion Policy," In Bernanke, Ben S., and Julio J. Roemberg, eds., NBER Macroeconomics Annual. Cambridge Mass.: MIT Press, 1995, pp Corrado, Carol, and Joe Maey, Capaciy Uilizaion", Journal of Economic Perspecives, Winer 1997, 11(1), pp Emery, Kenneh M., and Chih-Ping Chang, "Is There a Sable Relaionship Beween Capaciy Uilizaion and Inflaion?," Federal Reserve Bank of Dallas Economic Review, Firs Quarer 1997, pp Finn, Mary G., A Theory of he Capaciy Uilizaion/Inflaion Relaionship, Federal Reserve Bank of Richmond Economic Quarerly, Summer 1996, 82(3), pp Gordon, Rober J., "Commens" (on Mahew Shapiro), "Assessing he Federal Reserve's Measures of Capaciy Uilizaion," Brookings Papers on Economic Aciviy, 1989, 1, pp (1989a) Gordon, Rober J., "Hyseresis in Hisory: Was There Ever A Phillips Curve? American Economic Review, 79 (2), May 1989, pp (1989b) Gordon, Rober J., "Foundaions of he Goldilocks Economy: Supply Shocks and he Time-Varying NAIRU, Brookings Papers on Economic Aciviy, 1998, 2, pp McElhaan, Rose, "Inflaion, Supply Shocks and he Sable-Inflaion Rae of Capaciy Uilizaion," Federal Reserve Bank of San Francisco Economic Review, Winer 1985, 1, pp

14 Rich, Rober W., and Donald Rissmiller, Undersanding he Recen Behavior of U.S. Inflaion, Curren Issues in Economics and Finance, 6 (8), July 2000, Federal Reserve Bank of New York. Shapiro, Mahew, "Assessing he Federal Reserve's Measures of Capaciy Uilizaion," Brookings Papers on Economic Aciviy, 1989, 1, pp Tooell, Geoffrey M. B., "Globalizaion and US Inflaion", New England Economic Review, July/Augus 1998, pp Whelan, Karl, A Guide o he Use of Chain Aggregaed NIPA Daa, Federal Reserve Board Finance and Economics Discussion Paper No , June