Inflation In Open Economy Research Articles

Forecasting inflation in open economies: What can a NOEM model do?

AbstractThis paper evaluates the forecasting ability when inflation is viewed as an inherently global phenomenon through the lens of the workhorse New Open Economy Macro (NOEM) model. The NOEM model emphasizes the importance of cross‐country spillovers arising through trade, and its reduced form solution can be represented by a finite‐order VAR that provides a tractable model of inflation forecasting. We use Bayesian techniques to estimate this VAR specification—we name it NOEM‐BVAR—and pseudo‐out‐of‐sample forecasts to assess its forecasting performance at different horizons in a diverse set of 18 countries. On average, the NOEM‐BVAR specification produces a similar or even lower root mean square prediction error (RMSPE) than its standard competitors, which include both purely statistical models and theoretically‐based forecasting models (e.g., Phillips‐curve‐type alternatives and others with global inflation measures). In a number of cases, the gains in smaller RMSPEs are statistically significant, especially at short horizons. The NOEM‐BVAR model is also accurate in predicting the direction of change for inflation and is often better than its competitors along this dimension as well. Even though purely statistical models can be useful as prediction tools, the NOEM‐BVAR is an attractive tool among those forecasting models motivated by economic theory.

Inflation and Conflicting Claims in the Open Economy

ABSTRACT Exchange rates and international prices are fundamental to explaining inflation in open economies. Conflict inflation models account for these variables by including imported inputs and, sometimes, a distribution effect of exchange rates since firms' mark-up cannot be independent of foreign competition in open economies. We analyze the different assumptions on distribution underlying conflict inflation models. We propose an alternative approach building on the Classical–Keynesian theory of distribution for a price-taker open economy. Thus we model conflict inflation in a framework compatible with the Classical–Keynesian approach for the open economy. The model includes tradable prices, considering their direct impact on distribution. Therefore, it addresses a cause of inflation overlooked in the literature. Finally, conflict inflation affects the real exchange rate, which becomes a fundamental distributive variable.

Forecasting Inflation in Open Economies: What Can a NOEM Model DO?

Forecasting Inflation in Open Economies: What Can a NOEM Model DO?

Forecasting Inflation in Open Economies: What Can a NOEM Model DO? Supplementary Materials

Forecasting Inflation in Open Economies: What Can a NOEM Model DO? Supplementary Materials

The Macroeconomic Effects of Positive Trend Inflation in a Small Open Economy

ABSTRACT The existing New Keynesian open economy literature tends to make the simplifying assumption that there is no trend inflation. In this paper, we reformulate the standard open economy model to account for positive trend inflation. We then employ the model to understand the effects of macroeconomic shocks in a small open economy when trend inflation is positive. Our main finding is that allowing for trend inflation significantly affects the dynamics of the model through real exchange rate dynamics rather than the slope of the New Keynesian Philips Curve. Specifically, higher trend inflation induces modestly more persistent real exchange rates’ responses to the shocks. Further incorporation of trend inflation in an open economy enables us to discuss the Purchasing Power Parity and Delayed Overshooting Puzzles.

Optimal inflation, monetary integration, and asymmetric sticky prices

AbstractThis article explores the optimal rate of trend inflation in open economies with and without a monetary union, accounting for empirically observed differences in the degree of price stickiness across countries. In a closed economy, the optimal inflation rate is negative to offset the markup caused by imperfect competition. In an open economy there is a ‘beggar-thy-neighbour’ incentive and the optimal inflation is positive. Monetary union is globally welfare improving because it removes this externality. In both setups, as price stickiness increases, the degree of price dispersion increases, and the optimal inflation rate tends towards zero. Gains from monetary integration are higher for economies with more flexible prices.

Toward Inflation Targeting in Sri Lanka

This paper develops a practical model-based forecasting and policy analysis system (FPAS) to support a transition to an inflation forecast targeting regime in Sri Lanka. The FPAS model provides a relatively good forecast for inflation and a framework to evaluate policy trade-offs. The model simulations suggest that an open-economy inflation targeting rule can reduce macroeconomic volatility and anchor inflationary expectations given the size and type of shocks faced by the economy. Sri Lanka could aim to target a broad inflation range initially due to its susceptibility supply-side shocks while enhancing exchange rate flexibility and strengthening the effectiveness of monetary policy in the transition to an inflation forecast targeting regime.

Toward Inflation Targeting in Sri Lanka

This paper develops a practical model-based forecasting and policy analysis system (FPAS) to support a transition to an inflation forecast targeting regime in Sri Lanka. The FPAS model provides a relatively good forecast for inflation and a framework to evaluate policy trade-offs. The model simulations suggest that an open-economy inflation targeting rule can reduce macroeconomic volatility and anchor inflationary expectations given the size and type of shocks faced by the economy. Sri Lanka could aim to target a broad inflation range initially due to its susceptibility supply-side shocks while enhancing exchange rate flexibility and strengthening the effectiveness of monetary policy in the transition to an inflation forecast targeting regime.

On the real effects of inflation in open economies: theory and empirics

Based on the quarterly data from four open economies (the US, the UK, Canada, and Italy) and estimated correlations and impulse responses within the traditional vector autoregressive (VAR) analysis, we find that inflation, both in the short and long term, negatively affects consumption and investment, and has a positive influence on the current account. We propose an infinite-horizon optimizing model of an open economy with a fixed rate of time preference that explains these empirics. In this type of economy, households consume both durable and non-durable goods, firms operate under costly investment, and all the transactions involving consumption and investment are subject to cash-in-advance (CIA) constraints. Employing the new ‘sign restriction’ identification procedure due to Uhlig (J Mone’t Econ 52(2)381–419, 2005), we corroborate the empirical validity of the proposed model. In order to verify the robustness of our results, we consider another shock, namely, productivity shock in our empirical analysis and find that while productivity shock dominates in the case of the US, inflationary shock has a dominating effect in the case of the UK, Canada, and Italy.

Open economy inflation targeting arrangements and monetary policy rules

PurposeThe purpose of this paper is to explore whether India is a suitable candidate for an inflation targeting regime. It begins by placing India's monetary policy actions in a broader context by discussing whether the Reserve Bank of India (RBI) should shift from its current policy of heavily managed exchange rates to one involving greater currency flexibility. If the latter is chosen, the selection of inflation targeting would appear an appropriate one.Design/methodology/approachThis paper has analytical, empirical and policy dimensions. Given the recent history of exchange rate centered policy in India, a discussion of the role of the exchange rate is needed. This is presented by the use of an analytical model where we examine how inflation targeting might work with the exchange rate. Then the decision rule from the model (a monetary policy rule (MPR)) is adapted for empirical testing and is estimated to investigate whether an MPR that follows inflation targeting can work for India.FindingsThere is some evidence to suggest that the RBI follows an MPR quite inadvertently. The MPR (interest rates) tends to react to current inflation, but there is no evidence that it reacts to forecasts of inflation. Additionally, interest rates do not react at all to the exchange rate.Originality/valueThe RBI's operating policy framework and whether it should adopt an inflation targeting arrangement is a highly topical issue that has attracted a great deal of attention in policy discussions in India. Very few papers broach this topic systematically and combine the analytical and empirical considerations.

How large are the gains to commitment policy and optimal delegation for New Zealand?

This paper measures the benefits of commitment-based monetary policy over discretion for a small open economy inflation targeting country—New Zealand. Significant gains accrue from commitment policy. If commitment-based policy is unavailable, the government can recoup much of the gains to commitment through optimal delegation, asking the Reserve Bank of New Zealand to care more about inflation stabilisation. The 1999 PTA, the core of the policy contract between the New Zealand government and the Reserve Bank of New Zealand, placed an increased emphasis on stabilisation of output, interest rates and the exchange rate. This is inconsistent with a shift to optimal delegation behaviour and must stem from a changed perception of the welfare costs of macroeconomic stabilization on the part of the Government. This is shown to be true when the definition of inflation is extended to a medium term measure.

Inflation in Open Economies with Complete Markets

This paper uses an overlapping generations model to analyze monetary policy in a two-country model with asymmetric shocks. Agents insure against risk through the exchange of a complete set of real securities. Each central bank is able to commit to the contingent monetary policy rule that maximizes domestic welfare. In an attempt to improve their country's terms of trade of securities, central banks choose to commit to costly inflation in favorable states of nature. In equilibrium the effects on the terms of trade wash out, leaving both countries worse off. Countries facing asymmetric shocks may therefore gain from monetary cooperation.

Open-Economy Inflation- Forecast Targeting

Abstract We study simple inflation-forecast targeting in an open-economy setting. Simple inflation-forecast targeting implies setting an interest rate which, if kept unchanged throughout the forecast-targeting horizon, produces a conditional inflation forecast equal to the inflation target at the end of the horizon.We find that the optimal forecast-targeting horizon is relatively short (one year). A longer horizon does not consistently contribute to improved output stability, indeed it increases exchange rate variability and traded sector variability. The targeting procedure is substantially inferior to the optimal pre-commitment policy. Moreover, the targeting procedure does not necessarily determine the rational-expectations equilibrium and is subject to time inconsistency.

Open-economy inflation targeting

The paper examines inflation targeting in a small open economy with forward-looking aggregate supply and demand with microfoundations, and with stylized realistic lags in the different monetary-policy transmission channels. The paper compares strict and flexible targeting of CPI and domestic inflation, and inflation-targeting reaction functions and the Taylor rule. Flexible CPI-inflation targeting does not limit the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses.

Open-Economy Inflation Targeting

The paper extends previous analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand, and with stylized realistic lags in the different transmission channels for monetary policy. The paper compares targeting of CPI and domestic inflation, strict and exhibitable inflation targeting, inflation targeting instrument rules and the Taylor Rule, and inflation targeting and exchange-rate targeting. The paper also clarifies how a conditional inflation forecasts can be consistently constructed and used as an intermediate target variable when there are forward-looking expectations.

Government Purchases and Real Interest Rates

Government Purchases and Real Interest Rates

Inflation in an open economy : Tests with finnish data 1960(I)-1981 (IV)

Inflation in einer offenen Volkswirtschaft: Tests mit finnischen Daten von 1960(1) bis 1981(IV). — Es wird ein Modell entwickelt, um die Ansto\e zu untersuchen, die sowohl vom auslAndischen Angebot als auch von der inlAndischen Nachfrage ausgehen und die zu der international gesehen hohen Inflationsrate in Finnland beigetragen haben. Zu den ersteren Ansto\en zAhlen die PreisAnderungen importierter Zwischenprodukte und Rohstoffe, die in ein makrookonomisches Modell keynesianischen Typs eingebaut werden, wAhrend die Geldpolitik der zweiten Art von Ansto\en zugerechnet wird. Ein Transferfunktionsmodell mit zwei Inputs wird ermittelt und geschAtzt, um die verzogerten Wirkungen auf den Preis der inlandischen Produktion zu untersuchen. Die Ergebnisse deuten darauf hin, da\ die Reaktion auf auslAndische Preisansto\e recht schnell erfolgt: Innerhalb eines Jahres wird sich ungefAhr die HAlfte der Preisansto\e in einem Anstieg der Preise inlAndischer Produkte niederschlagen. Die monetAren Wirkungen auf die inlAndische Inflation sind aber auch auf kurze Sicht stark, obwohl sie mit einer langen Verzogerung eintreten. L’inflation dans une economie ouverte: Tests avec des donnees finnoises 1960(I) — 1981(IV). — L’inflation internationalement haute en Finlande est le point de reference de cette article. Les auteurs construisent un modele pour etudier les chocs d’offre etrangere aussi bien que les chocs de demande locale. Les chocs premierement nommes prennent la forme des changements de prix des biens intermediaires importes et des matieres premieres qui sont incorpores dans un macro modele du type keynesien. Les chocs dernierement nommes sont attribues a la politique monetaire. Les auteurs identifient et estiment un modele de fonction de transfert a deux inputs pour etudier les effets de retard distribues sur les prix de la production locale. Les resultats suggerent que la reponse des chocs de prix etranger est tres rapide: dans une annee a peu pres la moitie des chocs de prix sera absorbee par l’inflation de prix de la production locale. Les effets monetaires sur l’inflation locale sont cependant aussi forts a court terme bienqu’ils se passent avec un long retard. Inflacion en una economia abierta: tests con datos de Finlandia 1960(I) — 1981(IV). — El enfoque de este articulo es la inflacion internacionalmente alta de Finlandia. Se construye un modelo para estudiar tanto los choques de oferta externa como los choques de demanda interna. Los primeros toman la forma de variaciones de precios de bienes intermedios y materias primas importadas que se incorporan a un modelo keynesiano de tipo macro. Los Ultimos choques son atribuidos a la politica monetaria. Se identifica y estima el modelo de funcion de transferencia de dos elementos para estudiar los efectos de retardo distribuidos sobre los precios del producto domestico. Los resultados sugieren que la respuesta a choques de precios externos es bien rapida: dentro de un ano cerca de la mitad de los choques de precios sera absorbida por la inflacion de precios de producto domestico. Los efectos monetarios sobre la inflacion domestica son, sin embargo, tambien fuertes en el corto plazo a pesar de que se producen con un retardo largo.

The Impact of Demand and Cost Factors on Inflation in Open Economies

Bruno [1] develops a theoretical model of the wage-price adjustment process in an open economy to consider the dynamic impact of changes in import prices and exchange rates. In his model nominal wages are a function of the excess demand for labor, import prices (Pm) and an adaptive expectation term which is measured by a lag of the consumer price index (P C-l). The consumer price index (Pc) is a function of these three variables and the excess de-mand for home goods. Bruno finds that most of the variation of inflation rates for 16 OECD countries for 1972-76 is explained by the initial cost-push effect of the growth of import prices and the expectation of domestic inflation. This conclusion is based upon the empirical results obtained from estimating the pooled 64 cross-section and time series observations of a naive version of his model shown in equation (1).

An Empirical Macro-Model of an Open Economy under Fixed Exchange Rates: The United Kingdom, 1954-1970

At present, the student of the macroeconomics of inflation in open economies is confronted with a proliferation of competing, and often mutually inconsistent, models. It is our contention that empirical work is badly needed to bring some discipline to this area. In this paper, therefore, we construct a small-scale model that determines the behaviour of real income, prices, the balance of payments and the money supply in a fixed exchange rate open economy. We then subject the model as a whole to empirical testing against data drawn for the United Kingdom, and draw conclusions from that testing about which aspects of the model do appear to be consistent with the evidence and which do not. Thus we seek to make a threefold contribution. First, we present (yet another) small analytic model; second, we generate evidence about its empirical content; finally, and perhaps most important, we provide an example of how empirical work may be used to discipline and guide the process of model building even at a high degree of aggregation and abstraction.

Bank Credit, Money and Inflation in Open Economies. Edited by M. Fratianni and K. Tavernier, Berlin, Duncker & Humblot, 1976, VI p. 621 p., DM 78.00.

Bank Credit, Money and Inflation in Open Economies. Edited by M. Fratianni and K. Tavernier, Berlin, Duncker & Humblot, 1976, VI p. 621 p., DM 78.00.