A New Assessment of Openness and Inflation: Reply

Abstract

Terra [1998] argues that my finding [Romer 1993] of a negative relationship across countries between openness and inflation is actually caused by the severely indebted countries, over the debt crisis period. She proposes an explanation of the openness-inflation relationship based on indebted countries' need to raise revenue to repay their debts. The smaller a country's trade share, the more depreciated the real value of the currency must be in order to generate a given trade surplus as a share of GDP. And the more depreciated the currency, the greater the pressure on the government's budget-and thus the greater pressure to inflate. In contrast, in my paper I argue that the relationship stems from imperfect commitment in monetary policy. The less open the economy, the greater the benefits of surprise inflation, and thus the higher the level of inflation in the absence of complete commitment. Terra has uncovered interesting variation in the opennessinflation relationship across countries and over time. Nonetheless, I want to make three brief points that suggest that the channel she proposes accounts for only a modest part of the overall relationship. First, Terra's results do not justify her claim that the relationship is a product only of the severely indebted countries (SICs) during the debt crisis. This can be seen from her Table I. For the SICs, the openness-inflation link in the precrisis period, though weaker than during the crisis, is large and statistically significant. The estimates for the moderately indebted countries, although imprecise, suggest a relationship that is very similar to that for the SICs in both periods. And for the less indebted countries, the point estimates again suggest a negative relationship; indeed, for the full sample period the coefficient on openness is significantly different from zero. Only for the high-income countries (Terra's all other countries) is there no evidence of a negative association between openness and inflation.'