Abstract
The paper revisits the long-standing question of the impact of trade openness on the inflation–output trade-off by accounting for the effects of product market competition on price flexibility. The study develops a New-Keynesian open-economy dynamic stochastic general equilibrium model with non-constant price elasticity of demand and Calvo price setting in which the frequency of price adjustment is endogenously determined. It demonstrates that trade openness has two opposing effects on the sensitivity of inflation to output fluctuations. On the one hand, it raises strategic complementarity in firms' pricing decisions and the degree of real price rigidities, which makes inflation less responsive to changes in real marginal cost. On the other hand, it strengthens firms' incentives to adjust their prices, thereby reducing the degree of nominal price rigidities and increasing the sensitivity of inflation to changes in marginal cost. The study explains the positive relationship between competition and the frequency of price adjustment observed in the data. It also provides new insights into the effects of global economic integration on the Phillips Curve.
Highlights
The substantial increase in global economic integration during recent decades initiated a heated debate on the impact of trade openness on inflation and the short-run inflation–output trade-off
The analysis demonstrates that trade openness has two opposing effects on firms’ optimal pricing and inflation
This paper examined the impact of trade openness and product market competition on firms’ pricesetting decisions and the inflation–output trade-off
Summary
The substantial increase in global economic integration during recent decades initiated a heated debate on the impact of trade openness on inflation and the short-run inflation–output trade-off. The consumption aggregator is characterised by non-constant price elasticity of demand, which generates strategic complementarity in firms’ price-setting decisions in that a firm’s optimal price depends positively on the prices charged by its competitors It accounts for the negative impact of trade openness on firms’ steady-state mark-ups.. Greater trade integration and competition increases strategic complementarity in firms’ price-setting decisions and the degree of real price rigidities, which makes inflation less sensitive to changes in domestic economic conditions. An increase in trade integration and in the number of varieties available in the domestic market raises firms’ steady-state price elasticity of demand and lowers their desired mark-ups It increases the sensitivity of a firm’s profit-maximising price to the prices charged by its competitors.
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