Inflation dynamics and Globalization: Evidence from India
Syed Kanwar Abbas*
Abstract
The foreign resource capacity (globalization) affects inflation and real
economic activity. This paper shows that for a fast growing economy of India,
the foreign resource capacity has reduced inflation rate and changed the
process of inflation dynamics when globalization increased, as related to trade
liberalization policy in 1991. These results yield important policy implications
for the conduct of monetary policy.
Key words. Foreign resource capacity; Globalization; Inflation dynamics; New Keynesian Phillips Curve; India.
JEL Classification: E31, F41, F62
*Correspondence: Xi’an Jiaotong Liverpool University, International Business School Suzhou, 111 Ren’ai Road, Suzhou, Jiangsu, China.Email: [email protected] +86 (0) 512-8816-1670
Inflation dynamics and Globalization: Evidence from India
1. Introduction
The increasing role of foreign resource capacity (globalization) in
inflation process affects the ability of a central bank to stabilize inflation and
output gap. The recent theoretical contributions, in particular Woodford
(2007), discuss the impact of foreign resource capacity on inflation and
domestic output as well as the subsequent role of monetary policy in this era
of globalization. The empirical evidence for and against the sensitivity of
inflation to the foreign resource capacity is also equally emerging over time
(see Mishkin (2009) for discussions).
For a fast growing developing economy of India, the trade
liberalization policy was introduced in 1991, which increased an access of the
Indian firms to new imported inputs and increased their productivity and
performance leading to domestic product growth [Pinelopi K Goldberg et al.
(2010a; 2010b)].† This openness to trade policy is an important channel
through which the foreign resource capacity can affect the dynamics of
inflation and output. The reduction in imported intermediate input prices due
to increased globalization has direct impact on the marginal cost of domestic
firms. The reduction in the marginal cost decreases the overall price level. In
this context, the data show that inflation in India has significantly reduced
† India has important linkages with the global economy and for discussion see Rada andArnim (2014).
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from the early 1990s, and one of the plausible explanations, which we focus
on, is the potential effect of foreign resource capacity on inflation dynamics.
The earlier studies did not focus on the effect of foreign resource
capacity and it is believed that inflation dynamics cannot be explained by the
Phillips curve relationship, e.g., Phillips curve does not ‘exist’ for India (Paul
(2009)).‡ In this paper, we analyse the impact of foreign resource capacity on
inflation process by estimating a Phillips curve, which incorporates the impact
of foreign resource capacity on firms’ pricing behaviour. As a result, the
estimated reduced form parameters are micro-founded based on the ‘deep’
structural parameters and represent the optimal behaviour of economic agents.
The reduced-form equations of the New Keynesian Phillips curve, as
based on Woodford (2007), are estimated using empirical approach of the
generalized method of moments (GMM), which also takes into account the
potential endogeneity problem. The model is estimated over two different
sample periods, 1970-1990 and 1991-2009, respectively. The second sample
period covers the period when India started trade-liberalization policy and the
process of globalization increased over this sample period.
The results show that the foreign resource capacity affects inflation
process and has brought down inflation rate in India. The feedback from the
foreign resource capacity on the real economic activity describes inflation ‡ In macroeconomic theory, the Phillips curve is an important tool that is used to analyse
monetary policy and short-run process of inflation dynamics and is also widely used by the
central banks.
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dynamics, such as the foreign resource capacity affects inflation through
domestic output gap. The estimate of foreign resource capacity increases over
the second sub-sample period. This shows change in inflation process, and
inflation is also low and more stable after 1991. Inflation dynamics are
forward-looking and the lagged inflation does not drive current inflation. This
suggests that economic agents (firms) are forward looking in decision-making.
Our findings provide important policy implications. In particular, these
results are related to the conduct of monetary policy and suggest that the
central bank (the Reserve Bank of India) should consider the role of foreign
resource capacity to stabilize inflation and real economic activity (domestic
output gap) and also respond to the volatility of output, respectively. As
inflation is determined by the foreign resource capacity, this may affect the
ability of central bank to stabilize price level and full employment.
The paper is organized as follows. The theoretical model and
estimation framework are discussed in section 2. Section 3 discusses the data
construction while the results are discussed in Section 4. This is followed by
concluding remarks in section 5.
2. The model and estimation approach
The foreign resource capacity (globalization) affects real activity (i.e.,
domestic output) through trade integration, financial markets and also factor
markets (i.e., easy mobility of labour). This yields significant impact on price,
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profit and productivity of the domestic firms. Inflation process is determined
by both the domestic output gap and the foreign output gap as follows [see
Woodford (2007) for derivation].
π H ,t=βE t π H ,t +1+λH xd , t+λF x f , t+εt (1)
Where π H ,t is the domestic goods inflation, and where xd , t and x f , t are current
domestic output and foreign output, respectively. The ^ (hat) shows deviation
from the steady state approximated by the trend.ε t is an exogenous disturbance
term, which includes technology and preference shocks.β is the discount
factor.λH measures the sensitivity of inflation to the domestic output gap, and
where λF measures the sensitivity of inflation to the foreign output gap. The
reduced form coefficients (λH andλF ) are derived from the structural
equations that represent consumers and produces optimal choices.
Equation (1) captures the direct impact of foreign resource capacity on
domestic inflation. The foreign resource capacity also affects the current
domestic output and potential output of an economy. A few studies [Milani
(2010) and Zaniboni (2008)] discuss an indirect effect of the foreign resource
capacity on inflation through domestic output. To capture an indirect impact of
the foreign resource capacity on inflation, the aggregate output is defined by
the weighted average of both the domestic output and the foreign output.§
§ Zaniboni (2008) introduces the domestic output gap as a weighted average of both the
domestic output gap and the foreign output gap.
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π H ,t=βE t π H ,t +1+λ x t+εt (2)
xt=(1−h) xt , d+h xt , f +ζ t (3)
In this case, equation (3) shows the feedback from the foreign resource
capacity on the real activity. ** The weight (1-h) attached to the domestic
output gap shows bias in home consumption.ζ t may include other shocks (for
example interest rate through monetary policy and exchange rate through
competitiveness) on the domestic output,x t .
As a first step, the ordinary least squares (LS) is used while the
expected future inflation,π H ,t +1 , is endogenous and determined by other
macroeconomic fundamentals, e.g., interest rate. LS can produce biased and
inconsistent estimates. The generalized method of moments (GMM) is applied
to estimate equation (1) and (2), respectively. Under the assumption of rational
expectations, the errors in the forecast of,π H ,t +1 , are uncorrelated with
information t and earlier time periods. This can provide the following
orthogonality condition for equation (1).
Et {(π H , t−βπ H , t+1− λH xd , t−λF xf , t ) zt }=0
(4)
** The domestic output,x t , is endogenous and a few studies (Bardsen et al. (2004)) also
introduce the feedback from the lagged inflation on xt .
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Where zt is a vector of instruments and includes four lags each for inflation,
domestic output gap, foreign output gap and discount rate (percent per
annum).†† By substituting equation (3) into (2), the orthogonality condition for
equation (2) can also be written accordingly.
3. The data
Our sample period depends on the availability of the Indian data and
her trading partners’ data, which are used to construct the measure of foreign
resource capacity (foreign output gap). For India, the quarterly data of relevant
indicators (e.g., GDP deflator) start from 1996.‡‡ The quarterly data for major
Indian trading partners are not available in most cases, e.g., Saudi Arabia and
United Arab Emirates do not have quarterly data.§§ As a result, the annual time
series data ranging from 1970 to 2009 after sample adjustment is used in
estimation. The following variables are used.
The data on bilateral exports and imports of India with her respective
major trading partners are obtained from Direction of Trade Statistics. The
data on inflation and the real gross domestic product (GDP) at constant 2005
†† Instruments are valid and relevant based on Hansen J statistic and first-stage F-stat in all the
regression specifications.‡‡ The theoretical model, equations (1) and (2), relate domestic goods price inflation to
domestic output gap and foreign output gap. As a result, we focus on domestic goods price
inflation rather than consumer price inflation in empirical analysis.§§ We include ten largest trading partners, which are Belgium, China, Hong Kong, Germany,
Netherlands, Saudi Arabia, Singapore, United Arab Emirates, the United Kingdom and the
United States.
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prices (US dollar) are obtained from the United Nation’s Database. The
domestic output gap is calculated as the deviation of (log) real GDP from a
polynomial quadratic time trend. Following earlier studies (Borio and Filardo
(2007) and Ihrig et al. (2010)), the foreign output is constructed as a weighted
average of the real GDP of the trading partners, and the trade-weights are
calculated using imports and exports of trading partners. The foreign output is
defined by y f , t=∑
j=1
10
w tj y t
j
and, where
w tj=
Exportstj+Importst
j
∑j=1
10
( Exportstj+ Importst
j ).We use one period lagged
time varying trade weights,w t−1j
, to avoid potential endogeneity. Like the
domestic output gap, the foreign output is also de-trended with a fitted
quadratic time trend. The movements in the domestic output gap follow the
foreign output gap especially in the early 1990s when the trade liberalization
policy was introduced in India (see figure 1).
4. The results
The results with GMM by substituting equation (3) into (2) (ignoring
constant) yields
π H ,t=0. 692 π H , t+1−0 .193 [0 .769 { xt ,d+0 .231 { xt , f ]+ε t ¿ (0 .041) (0. 041) (0 . 068 ) ¿GMM, Hansen's J chi2(13 ) = 3 .85 [0 .99 ] ¿ Sample period after adjustment: 1970-2009 ¿¿The estimates are efficient and robust for arbitrary heteroskedasticity and
autocorrelation. The heteroskedasticity and autocorrelation-robust (HAC)
standard errors based on Bartlett kernel with lags chosen by the Newey-West
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method are reported in parentheses. According to these results, the foreign
resource capacity plays an important role in inflation process. If we estimate
over the sub sample when the trade liberalization policy was introduced in
1991, the share of foreign resource capacity increases from 0.23 to 0.89 and it
is also greater than the domestic output.
π H ,t=0. 810 πH , t+1−0 .138[0 .105 { xt , d+0 .895 { xt , f ]+ε t ¿ ( 0.018 ) (0 .033) (0 .19) ¿GMM, Hansen's J chi2(13) = 2.69 [0 .99 ] , ¿ Sample period: 1991-2009 ¿¿The coefficient on the foreign resource capacity is positive and statistically
significant in both the full and sub sample periods suggesting that the foreign
resource capacity is an important driving force of inflation. The other
important observation is that the coefficient on expected inflation (the discount
factor,β ) is increasing over time.β should lie between 0 and 1, and
empirically closer to 1 (i.e., 0.99). However, it is 0.81, as suggestively less
than one, which shows that economic agents place less weight on future
inflation in India. This shows a durable long run trade-off between inflation
and output gap (or unemployment). On the other hand, the increase in the size
of coefficient onβ from 0.69 to 0.81 also shows that inflation dynamics are
forward looking in India.***
*** We also estimated the hybrid new Keynesian Phillips curve with both future and lagged inflation to confirm these findings. The results are available upon request.
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Common to the full and sub sample results, the slope coefficient,λ , is
incorrectly signed (negative) and this finding is also robust if the share of
foreign resource capacity is considered zero (i.e., h=0 that yields the baseline
new Keynesian Phillips curve). There are different explanations for this, and
one of the arguments, as developed by Gali and Gertler (1999), is that the
output gap is not a good proxy for real activity compared to the marginal cost.
For India, the discussion either the marginal cost or output gap is a good proxy
for real activity is beyond the scope of the present paper. In particular, we find
that the negative sign onλ yields the incorrect sign (negative) on the
coefficient of foreign output gap, as observed below from the GMM estimates
of equation (1). This may produce incorrect conclusion that the share of
foreign resource capacity does not affect inflation dynamics.
π H ,t=0.654 π H , t+1-0 .255 { xt , d -0 .0721 { x t , f +εt ¿ (0 .036) (0. 0273 ) (0 .00932) ¿GMM, Hansen's J chi2 (15) = 2 .98 [0.99 ] , ¿ Sample period after adjustment: 1970-2009 ¿¿The heteroskedasticity and autocorrelation-robust (HAC) standard errors
based on Bartlett kernel with lags chosen by the Newey-West method are
reported in parentheses. The set of instruments is same as used before and
consists of four lags each for inflation, domestic output gap, foreign output
gap and discount rate (percent per annum). Contrary to the theoretical
predictions, the estimate of foreign output gap(-0 . 0721)and the estimate of
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domestic output gap( -0 .255)are incorrectly signed (negative) though both
these coefficients are statistically significant.†††
The foreign resource capacity has changed process of inflation
dynamics. In figure 2, we plot the expected inflation (as derived from the first-
stage regression fitted values from the regression of expected inflation at t+1
on instruments) and real economic activity (measured as fitted values from the
regression of domestic output gap on lagged domestic output gap and lagged
foreign output gap). It is observed that the increasing share of foreign resource
capacity in domestic activity from 1991 has affected inflation process and also
decreased inflation rate in India over time.
5. Concluding remarks
The foreign resource capacity affects inflation and real economic
activity. This paper provides an evidence that for a fast growing Indian
economy, the foreign resource capacity has reduced inflation rate and changed
the process of inflation dynamics when globalization increased, as related to
trade liberalization policy in 1991. These results suggest important policy
implications about the conduct of monetary policy, which should take into the
role of foreign resource capacity to stabilize domestic inflation and real
economic activity in India.
References††† The results are qualitatively similar over the sub-sample period (1991-2009) and are available upon request.
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FIGURE 1. INDIAN DOMESTIC GAP AND FOREIGN OUTPUT GAP-.3
-.2-.1
0.1
.2
1970 1980 1990 2000 2010t
India Output Gap India Foreign Output Gap
FIGURE 2. EXPECTED INFLATION AND REAL ACTIVITY
-.05
0.0
5.1
.15
1970 1980 1990 2000 2010t
expected inflation estimated output gap
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