Globalization, inflation and monetary policy

The thesis is aimed at investigating the implications of globalization for the conduct of monetary policy. By globalization we mean increased interdependence of national economies as reflected in greater and freer flow of goods, services, capital, and labour across national borders. In particular, our research addresses a number of important issues in the recent monetary policy and globalization debate. First, are global factors becoming important drivers of domestic inflation? Second, are global factors playing more powerful role on inflation dynamics in the sectors of an economy that are more open to trade? Third, has globalization made the job of Central Bankers more difficult? And finally, do the Central Bankers in the United States and the United Kingdom consider international factors too along with domestic factors while determining the short term interest rates? Inflation rates have been observed to be low across industrial countries since the early 1990s. The co-movements of inflation rates across countries are strikingly high. We model the co-movements of inflation rates by a global factor, regional factors and idiosyncratic component. In particular, we estimate a Dynamic Factor Model with Stochastic Volatility and find that the contribution of the global factor has increased over time in explaining the variance of inflation in OECD countries. The regional factor also gains importance in countries with strong intra-regional economic linkages potentially due to proliferation of regional trade agreements and common currency areas. In the European countries, the role of global and regional factor together dominates the country specific factor since the late 1990s. The volatility of inflation has substantially decreased over time and our modelling framework incorporates time varying volatility of inflation. We find strong positive and significant relationship between the international common factor and economic globalization. Consistent with inflation becoming a global phenomenon, co-movements of aggregate inflation between countries are observed to be high. We examine whether this is also the case for sectoral inflation, we model the co-movements in sectoral inflation as being associated with a global factor, a sector specific factor and an idiosyncratic error term. We find that the co-movements of inflation of tradable sectors are substantially greater than the co-movements in non-tradable sectors which implies that the greater co-movements of inflation can be attributed to increased trade global integration of product markets. To test this, we attempt to find empirical relationship between the estimated common factor in sectors and openness to trade measured as import penetration. A positive relationship is found between the estimated sector specific common factors and import penetration. Given our earlier chapters identify important global dimension to aggregate and sectoral inflation, does this matter for monetary policy? The implication of globalization for monetary policy in the United States and the United Kingdom are examined by estimating monetary policy reaction function for these advanced economies over the sample period 1985-2010. We also consider time variations in these reaction function by estimating over a sub-sample of 1992-2010 for the United Kingdom and the Greenspan-Bernanke Era for the United States. We estimate the policy reaction function with domestic and global inflation and output gaps and with the component of domestic inflation and output gap that is not related to global variations. The policy reaction function augmented with foreign variables such as real effective exchange rate and foreign interest rate is also estimated. We use measures of inflation based on GDP deflator, CPI and inflation expectations. We find that the Federal Reserve responds to global inflation only in the full sample and to global as well as the country specific inflation in the second sub-sample (Greenspan-Bernanke Era). This may imply strong commitment of the Federal Reserve to the goal of ``price stability'' during Greenspan-Bernanke Era. The Bank of England responds to global inflation along with the country specific inflation. The international factors such as the real effective exchange rate changes (depreciation) and foreign interest rates have significant and positive effect on policy rates.