3. Model Specification
The analysis from the previous section suggests that there is a sizeable common component driving world inflation rates. What forces are behind the significance of this global factor? This section employs the Phillips curve to explore the underlying driving factors that may help explain the growing influence of the common component in worldwide inflation rates.
According to the Phillips curve relation, an important driver of inflation in the short-run is the amount of economic `slack' in the country, as proxied by the domestic output gap. From this perspective,
a common component in national inflation rates may reflect greater co-movement in domestic output gaps driven by fluctuations in global output and exchange rates.
However, this does not seem to be supported by the data. A number of studies indicate that the link between inflation and the domestic output gap since the 1990s has generally weakened, and disappeared altogether in some cases. This finding is relatively robust, and has been widely referred to as the 'flattening' of the Phillips curve1. To explain this phenomenon, Razin and Yuen, Razin and Loungani, and Razin and Binyamini cite the effects of globalization whereby both the opening of the capital account and trade balance flattened the Phillips curve through channels such as enhanced consumption smoothing and greater consumption diversification.
In light of these evidences, a common view is that the process of globalization may have supplanted the role of the domestic output gap in Phillip curve models with global economic measures of slack - defined as the difference between world demand and estimated world potential supply. In other words, as internationalization of goods and factor markets have gathered momentum, it has been suggested that national inflation rates may have become more sensitive to resource utilization at the global, rather than domestic, level. For instance, Bullard argues that the reason why US inflation has not fallen more in the aftermath of the 2007 crisis despite large negative domestic output gaps is because they have become more dependent on the state of global capacity, which is substantially tighter. A number of policymakers have taken interest in this so-called globalization hypothesis (GH), as whether domestic inflation has become more sensitive to foreign cyclical conditions has important implications for the formulation of monetary policy.
Despite the intuitive appeal of the GH, the issue as to whether the global slack can empirically explain the movements in inflation data is still subject to considerable debate. On the one hand, a widely cited study by Borio and Filardo provides strong evidence that the foreign output gap helps explain inflation dynamics in 17 OECD economies during the 1985-2005 period. Gamber and Hung and Wynne and Kersting also confirm the importance of the global output gap for the US. However, the robustness of Borio and Filardo's results have been challenged by Ihrig et al. (2010), where they show that the importance of the global output gap for inflation disappears with plausible alternative specifications of the reduced form Phillips curve. These results are confirmed by Pain based on a system of error correction models as well as by Ball (2006) using panel regression analyses for a number of OECD countries.
Milani reaches the same conclusion by estimating a structural model for a sample of G7 economies over the 1985-2007 time period. Conflicting evidence is also present in earlier work.