Globalization, market structure and inflation dynamics

Abstract

The decline in the sensitivity of inflation to domestic slack observed in developed countries since the mid-1980s has been often attributed to globalization. However, this intuition has so far not been formalized. I develop a general equilibrium setup in which the sensitivity of inflation to marginal cost decreases in response to a fall in trade costs. In order to do so, I add three ingredients to an otherwise standard two-country new-Keynesian model: strategic interactions, endogenous entry of exporters and heterogeneous productivity. Because of differences in firms productivity, only high-productivity firms (that are also the larger ones) start exporting when international trade cost falls. These firms transmit less marginal cost fluctuations to their prices, rather strategically absorbing them into their desired markup. At the aggregate level, the increase in the proportion of large firms makes inflation respond less to real activity fluctuations. A simple calibration of the model shows that globalization could explain around one fifth to one third of the flattening of the Phillips curve in the United States from the early 1980s to mid-2000s.