Globalization, Pass-Through and In‡ation
Dynamic¤
Pierpaolo Benigno
LUISS Guido Carli and EIEF
Ester Faia
Goethe University Frankfurt, Kiel IfW and CEPREMAP
March 2010

Abstract
An important aspect of the globalization process is the increase in interdependence among countries through the deepening of trade linkages. This process should
increase competition in each destination market and change the pricing behavior of…rms. We present an extension of Dornbusch (1987)’s model to analyze the extent towhich globalization, interpreted as an increase in the number of foreign products ineach destination market, modi…es the slope and the position of the New-Keynesian
aggregate-supply equation and, at the same time, a¤ects the degree of exchangerate pass-through. We provide empirical evidence that supports the results of ourmodel.

¤We are grateful to the Fondation Banque de France for a grant sponsoring this project. We thankMatteo Bugamelli, Linda Goldberg, Luca Guerrieri, Argia Sbordone, Yuki Teranishi, for helpful suggestions and comments and seminar partecipants at the Banque de France, ESSIM and at the conferenceon “Globalization and Monetary Policy” organized by the Bank of Korea and Bank of Canada. Eleni
Iliopulos and Hermes Morgavi have provided excellent research assistanship.

1

Introduction

The increased interdependence among countries through the deepening of trade linkages ingoods and …nancial assets, spurred by the so-called process of globalization, has attracted
the attention of economists and policy makers. One important theme, which has been
the subject of considerable discussion, has been the ‘global slack’ hypothesis, namely theincreased dependence of in‡ation dynamics on global factors rather than just on domestic
economic activity.1
This paper focuses on two channels through which globalization a¤ects in‡ation dynamics. First, we ask how globalization, interpreted as an increase in the presence of
foreign goods in the domestic market, a¤ects the pass-through of foreign marginal costs
and the exchange rate into import prices, through its in‡uence on the degree of competition. As a large fraction of consumption and intermediate goods is represented byimported goods, the overall price index becomes more sensitive to external conditions,
namely the combined dynamic of nominal exchange rate and foreign marginal costs.2 The
second channel through which globalization in‡uences the dynamic of in‡ation is, indirectly, through its e¤ect on the pricing strategies of domestic …rms selling in the internalmarket. The latter channel a¤ects the slope and the position of the aggregate-supply
equation.
To address these issues we extend the Dornbusch’s [16] model to a dynamic context
with price stickiness. Domestic and foreign …rms compete in a strategic way to increase
their market shares through their pricing decisions. In this context, the mark-up is afunction of a …rm’s market share, which in turn is a function of competitors’ prices andmarginal costs. Hence domestic and foreign marginal costs a¤ect each other through theirin‡uence on …rms’ market shares and mark-ups.
We study the implications of this model for the exchange-rate pass-through and the
dynamic of prices set by foreign and domestic …rms in the domestic market.
On the one side, we show that the degree of exchange-rate pass-through depends on the
degree of concentration in the market and in particular on the share of foreign productsin the market. Greater competition, due to the increase in the share of foreign products
sold in a speci…c industry – a phenomenon strongly connected to globalization – raises
the degree of exchange-rate pass-through, both in the short and the long run. Throughthis channel, globalization ampli…es the dependence of in‡ation for imported goods upon
external conditions. Our theoretical results are con…rmed through an empirical analysis
1

See among others Bernanke [4], Borio and Filardo [7], Fisher [18], Rogo¤ [31].
Globalization also implies that agents have access to a larger variety of goods, due to the increase in
the intensity of trade and in the number of trading partners. We do not explore this additional dimension.
2

1

based on manufacturing sectors in the US. Indeed, there is evidence of an increase in
the degree of exchange rate pass-through exactly at the time in which the globalization
process took place.
On the other side, our framework has important implications for the reduced form of
the New-Keynesian Phillips curve. The Phillips curve of our model is augmented by alink between domestic in‡ation and the market share of domestic …rms, with the latterproxied by the relative price of foreign versus domestic products. This channel re‡ects
the strategic competition in pricing between domestic and foreign …rms, which in‡uences
directly the in‡ation dynamic of domestic …rms, even when domestic marginal costs do
not vary. The presence of foreign prices into the new augmented Phillips curve creates alink between domestic in‡ation and foreign marginal costs, which in turn is connected to
the foreign output gap. This is the essence of the ‘global-slack’ hypothesis.
In traditional open economy models, domestic real marginal costs are a¤ected byterms of trade (see Benigno and Benigno [3]) which can shift the Phillips curve for given
domestic output gap. This channel runs as follows. When foreign prices decrease andterms of trade improve, there are in‡ationary pressure on domestic prices. This shifts thePhillips curve upward. However, Woodford [39] has pointed out that such shift is at odd
with the common wisdom regarding the e¤ects of globalization on in‡ation dynamic. The
relative-price channel emphasized by our model moves instead the Phillips curve consistently with the global-slack hypothesis: downward (upward) when foreign prices decrease(increase). In addition, we show that the degree of market concentration also in‡uences
the slope of the Phillips curve, namely the sensitivity of in‡ation to marginal costs. Higher
competition, captured by a higher number of …rms in the market, steepens the Phillips
curve, implying that domestic prices become more sensitive to domestic marginal costs.
We provide support for the relative-price channel by estimating, with US data on
the non-farm business sector and the manufacturing sector, the reduced form Phillips
curve implied by our model. Such channel is more evident in the manufacturing sector,
as the latter is more exposed to the globalization process. Over the last decade unit
labour costs and prices have indeed decreased in this sector while they have increased in
the manufacturing sector. Consistently with the results highlighted in our model, thispattern is well explained by the rise in the manufacturing import price, namely the priceof competitors.
The rest of the paper proceeds as follows. Section 2 discusses the relation of our paperwith the most recent literature on the e¤ects of globalization on in‡ation dynamics andpass-through. Section 3 shows the model. Section 4 solves the model under ‡exible prices.
Section 5 solves the model under sticky prices. Section 6 discusses the empirical analysis
2

on the exchange rate pass-through and that on the domestic AS equation. Section 7
concludes.

2Comparison with the LiteratureThis work is related to a recent literature that has addressed the implications of globalization for the reduced form of the Phillips curve. Sbordone’s [36] presents a modi…cationof the standard Calvo’s [10] pricing mechanism by allowing for time-varying elasticity ofdemand using Kimball’s [30] preferences. It follows that the number of variety produced
in a sector a¤ects the degree of strategic complementarity in price setting, and hence in‡uences the dynamic response of in‡ation to marginal costs. She …nds that an increase intrade globalization reduces the slope of the Phillips curve only under certain parameters’
con…guration. Sbordone [36] uses a closed-economy model and focuses on the slope of thePhillips curve. Instead, Guerrieri et al. [25] apply Kimball’s [30] preferences to an openeconomy model in which the elasticity of demand depends upon the ratio of domestic
prices to foreign competitors’ prices. They show that this type of preferences implies
a new reduced form for the New-Keynesian Phillips curve, in which domestic in‡ation
depends on the ratio between prices of imported goods and domestic prices, alongsidewith domestic real marginal cost. The reduced form of the Phillips curve derived in Guerrieri et al. [25] is observationally equivalent to the one derived in our model, although
micro-foundations are signi…cantly di¤erent. Since we model variable mark-up throughstrategic pricing we are able to highlight the pro-competitive dimension backing the relation between in‡ation and globalization. Finally, Bilbiie et al. [5] and Cecioni [13], ina closed-economy context, have emphasized the role of changes in the total number ofvarieties for the dynamic of marginal costs. On the contrary, in our model we show thatthe mark-up can vary even when holding constant the domestic marginal costs and thenumber of traded varieties and as a result of relative price changes.
The competitive e¤ect of globalization in our model resembles the one explored in
Chen, Imbs and Scott [14]. They test the heterogenous-…rm model of Melitz and Ottaviano [29], according to which greater competition by foreign …rms and an increased shareof imports induce a fall in pro…t margins and markups. There are important di¤erences
between our approach and theirs: …rst …rms’ heterogeneity is not essential in our framework as competition is determined by the oligopolistic structure; second our model also
accounts for long-run dynamics.
Our paper contains several implications about the impact of globalization on the degreeof pass-through. In this respect it is useful to compare our results to the most recent
3literature on exchange rate pass-through.3 Gopinath and Itskhoki [22] …nd a robust link
between pass-through and the duration of price adjustment and show that the latter is verymuch related to variations in mark-ups. Gopinath and Rigobon [23] look at data with highlevel of dis-aggregation and …nd that the probability of price adjustment of US imports has
decreased. Moreover, they show that the exchange rate pass-through is inversely related
to the probability of price adjustment. Campa and Goldberg [12] and Sekine [34] havefound that the sensitivity of retail prices to exchange rates changes may have decreased in
the last decade. However, Campa and Goldberg [12] do not …nd signi…cant evidence for
the United States. Our results, indeed, point strongly in this direction as we show thatthe degree of pass-through has increased for some US manufacturing sectors during theperiod 2001-2009. For this time span we document a stronger correlation between pricevariations and exchange-rate changes than for previous periods. Gust et al. [26] also argue
that the increase in trade integration, observed over the last decades, has decreased thedegree of exchange rate pass-through. However, their results are based on a comparisonof di¤erent set of time samples, namely the 80s versus the 90s, and on di¤erent sectors.
We focus our analysis on the last …fteen years and analyze data for the manufacturingsector. As discussed above, imperfect pass-through in the Gust et al. [26] is obtainedby introducing Kimball’s [30] preferences and this might limit the ability of their model
to trace the parameters of the Phillips curve with reference to the competitive pressure
experienced during the globalization process.
The relationship between market share and exchange rate pass-through has …rst beentested by Feenstra et al. [17], who shows that pass-through should be high for exporters with large market shares. Our model features a dynamic dimension that allows todisentangle short-run versus long-run pass-through and accounts for the e¤ects of expectations. Finally, Bodnar et al. [6] have also estimated the degree of exchange ratepass-through using a model in which competition between domestic and foreign …rms ismodelled using elements from the industrial organization literature. However Bodnar etal. [6] focus mainly on the relationship between the exposure of …rms’ pro…ts to exchange
rate ‡uctuations and the exchange rate pass-through.
Our work is also related to the vast literature estimating New-Keynesian Phillips
curves, more closely to the analysis conducted by Sbordone [35] and Guerrieri et al. [25].
Although we refer to di¤erent type of micro-foundations, we largely con…rm the results in
Guerrieri et al. [25] regarding the importance of the relative-price channel in the Phillips
curve.
3

See also Goldberg and Knetter [24].

4

3

A model of international strategic pricing

We analyze a two-country model in which the home economy is indexed by  and theforeign economy by  . In each economy there are multiple sectors, indexed by . In eachsector of the home country, there are  di¤erentiated goods, of which  are produced
by …rms residing in country  and the remaining  by …rms residing in country  .
Similarly in country  there are  ¤ di¤erentiated goods, of which ¤ are produced by…rms residing in country  and ¤ by …rms residing in country  . Assuming that in eachsector individual varieties are aggregated according to a Dixit-Stiglitz aggregator, optimal
demand for a generic good  produced in country  and belonging to a sector  is given
by:


 = ( )¡ ( )¡ (1)where  is the elasticity of substitution among di¤erent varieties produced in the genericsector  and  is the elasticity of substitution across sectors. We de…ne the overall demandin the economy,  , the economy-wide price index,  , the price of good ,   and theaggregate price of the sector   , with the latter given by:X = (

1¡ +

=1


X

1

1¡ ) 1¡

(2)

=1

where  denotes the price of a generic good  in the sector , produced in country  .
Following Dornbusch [16], we assume that …rms are not small with respect to theirsector meaning that, in their pricing decisions, they internalize the fact that they canin‡uence the sectorial price.4 The elasticity of demand of good  with respect to its price is not necessarily constant and is instead given by:   = ¡ + ¡   

(3)

which can be written in a more compact form, and in absolute value, as:4¯¯¯   ¯
¯ =  ¡ ( ¡ ) ~  ´ ¯¯  ¯(4)Feenstra et al. [17] present a similar model. Instead, Soto and Selaive [37] develop a general equilibrium model in which …rms compete on quantities rather than on prices. Atkeson and Burstein [1] study
also a ‡exible-price model with strategic competition in quantities.

5

where   identi…es the market share of …rm  in sector  given by
 ´

 
 =  

(5)

The elasticity of demand faced by the generic …rm , ~  , boils down to that of monopolistic competition under two cases. The …rst when all …rms are small, i.e. when theirmarket share goes to zero,   ! 0 The second case occurs when the demand elasticity across di¤erent varieties and that across di¤erent sectors coincide,  = ; under
this condition …rms do not have leverage in a¤ecting sectorial aggregate prices. The
empirically-relevant case is that in which the elasticity across di¤erent varieties, within
a single sector, is higher than that across sectors,   . In this case ~  is a decreasing
function of …rm´s  market share. In the limiting case in which there is only one …rm  ineach sector we can obtain that ~  = . Intuitively monopoly power rises with the market
share.
The equilibrium is symmetric since all …rms in a sector face the same technology andoptimization problem. Therefore we drop the index . The market share of …rms basedin country  is then given by =  =    +   (6)

where  ,  ,  ,  are prices and output in country  for …rms resident respectively incountry  and  .
Our model implies that variation in the market share causes changes in the markup. Since relative prices in‡uence the market shares, …rms internalize the impact of
their pricing decisions on the overall market equilibrium. An important implication isthat prices become more sensitive to other …rms’ marginal costs and, with international
competition, to exchange rate ‡uctuations. We label this channel as the pro-competitivee¤ect since it echoes the ones analyzed in Ghironi and Melitz [5], Melitz and Ottaviano[29] and Chen, Imbs and Scott [14] in models that allow for …rm heterogeneity. Notice that
this pro-competitive channel survives in our model even in absence of …rm heterogeneity
because of strategic pricing competition.
As mentioned earlier, we focus on one aspect of the globalization process, namely theincrease in the number of foreign products in the domestic market. Such an increase
reduces the market share of both domestic and foreign …rms, therefore increases theelasticity ~  and reduces the monopoly power. First, we study the model’s implications
for the sensitivity of prices to marginal costs and, in particular, we analyze the degree6

of exchange rate pass-through, when prices are fully ‡exible prices. Later, we introduce
sticky prices.

4

Flexible prices

Under ‡exible prices, a …rm  producing and selling in country  chooses  to maximize
the following pro…t function:¦ =   ¡

(7)

under the demand function (1), where  are the nominal wages in the labor market ofcountry  and  denotes a common productivity shifter in country . The production
function is assumed to be linear in labor, the only factor of production.
Standard optimization implies the following …rst-order condition: =~  ~  ¡ 1 

(8)which shows that prices are set as a time-varying mark-up over marginal costs, where ~ 
is given by (4). Since all …rms face the same problem, they will set the same price. We
can therefore eliminate the index  and introduce the index  or  indicating the countryof residence of the …rm. Prices set by domestic …rms selling in market  reads as follows: =~  ~  ¡ 1 

(9)while prices of foreign …rms selling in market  are: =~   ¤~  ¡ 1 ¤(10)

in which  denotes the nominal exchange rate (the price of foreign currency in terms ofdomestic currency), ¤ denotes nominal wages determined in a foreign labour market(denominated in foreign currency) and ¤ is the common productivity shifter for …rms
based in country  . Prices (9) and (10) have to be solved jointly since the market sharesof domestic …rms   , as shown in equation (6), and that of foreign …rms,    depend
themselves on prices.
To analyze more deeply the implications of conditions (9) and (10), it is convenient totake a log-linear approximation together with that of the market shares to obtain^  ¡ ^^ =  (^ ¡ ^ ) + 
7(11)^ ¤ + ^ ¡ ^¤^ =  (^ ¡ ^ ) + (12)where the parameter  is de…ned by´¡1¡ 1

¹¡1 
¹ 

with 
¹ ´  ¡ ( ¡ )  =   and  =   and where variables with a hat
denote log-deviation with respect to the steady-state.

4.1

Exchange-rate pass-throughUsing the reduced form implied by equations (11) and (12) it is possible to study theconditions under which there is full pass-through of exchange-rate movements into foreign
prices. Pass-through is de…ned as the response of the prices set by the foreign …rms (sellingin the market ) to movements in the exchange rate, i.e.  ^ ^  Pass-through is fullwhen the response is unitary.
Proposition 1. With ‡exible prices, the degree of pass-through is unitary when oneof the following condition is met: 1)  = ; 2)  ! 1; 3)  = 0Consider the …rst condition,  = . In this case the elasticity of demand, ~   is constantand independent of the market shares. Firms cannot a¤ect sectorial aggregate prices andtherefore a constant elasticity of demand implies full pass-through. The power of …rms
to a¤ect sectorial aggregate prices is also nil under the second condition,  ! 1 In thiscase, the market share of each …rm becomes negligible like in a monopolistic-competitivemarket. Finally, in the third case ( = 0), foreign …rms dominate completely the domestic
market and so they can pass-through any exchange-rate movement into prices without
losing market share.
To summarize, pass-through in the ‡exible-price equilibrium is high when foreign …rms
have larger market shares or are very small. In the intermediate cases, the pass-throughis less than unitary because …rms internalize the e¤ects of their pricing choices on themarket shares. Indeed …rms foresee that too large price increases lead to signi…cant losses
in market share and thus to reductions in the mark-up. Therefore, they do not increaseprices much when the exchange rate depreciates.
Figure 1 quanti…es the exchange-rate pass-through as a function of the share of foreign
products in the market, which is our measure of the dimension of globalization in themodel. Calibration of baseline parameters is as follows:  = 6  = 15 We interpretthe rise in the number of foreign products in the domestic market as an increase in8

globalization. Given a permanent shock to the exchange rate, the two panels in Figure
1 show the degree of pass-through as a function of the share of foreign products in thedomestic market. The left panel shows how the degree of pass-through varies when thefraction of foreign products in the market changes on the ¡axis and for di¤erent valuesof . Along each line we keep the total numbers of products in the market constant. The
right panel instead shows the degree of pass-through against the share of foreign products
and for di¤erent values of   In this case, along each line we keep  at a determinedvalue and vary the number of foreign products, and therefore the total number of products.
Both pictures show that the pass-through is increasing in the share of foreign products inthe market. Consistent with the theoretical results, the pass-through is one when foreign…rms dominate the market. Globalization, interpreted as an increase in the fraction offoreign products in the domestic market, leads to higher long-run pass-through and makes
foreign prices more responsive to foreign marginal costs and the exchange rate. Moreover
the pass-through is larger in sectors characterized by a low degree of concentration, whichin our model can be proxied by the inverse of the total number of …rms in the market,
i.e. 1 . For large values of  the degree of concentration in the sector is low and thepass-through is very close to one.

4.2

Response of domestic prices to domestic conditions

Over the recent years a large part of the debate on the costs and bene…ts of the globalization process has pointed toward the possibility that domestic prices could be disconnectedfrom domestic conditions and more in‡uenced by external factors. To the extent that domestic prices are largely driven by foreign marginal costs, the interventions of policy
makers to constrain in‡ation by restraining domestic demand might become less e¤ective. To study the link between domestic prices and marginal costs, we take the di¤erence
between equations (11) and (12) and solve for the equilibrium prices: ^ ¤ ^1 + (1 ¡  ) ^^ =
( +  ¡ ^¤ ) +( ¡ ^ )
1+
1+

(13)

 ^
1 + (1 ¡  ) ^ ¤ ^^ =
( ¡ ^ ) +( +  ¡ ^¤ )
1+
1+

(14)

Equation (13) shows that prices of domestic …rms selling in market  are a weighted
average of domestic and foreign marginal costs. A standard model with monopolisticcompetition would instead imply prices to be just in‡uenced by domestic marginal costs.
Similarly, prices of foreign products sold in the market  are a weighted average of domestic
and foreign marginal costs. The pricing competition between domestic and foreign …rms
9

creates a link through which movements in marginal costs spillover across …rms competingin the same sector. The degree of marginal cost spillover is a¤ected by the share offoreign …rms operating in the market. An increase in the share of foreign products,  
tends to foster the link between domestic prices and foreign marginal costs. On reverse
globalization in terms of higher penetration of foreign …rms in the domestic market tends
to weaken the link between domestic prices and domestic marginal costs. Our model would
then be consistent with the ‘global slack’ hypothesis according to which the dynamic ofdomestic prices is more in‡uenced by the foreign slack as a consequence of globalization.
Figure 2 plots the response of prices to a shock to domestic wages for the …rms based incountry  and selling products in country . Once again two di¤erent cases are examined.
The left-hand side panel of Figure 2 shows how the response of domestic prices to domestic
wages varies with respect to changes in the fraction of foreign products (on the /axis)
and for di¤erent/given values of  . The right-hand side panel of Figure 2 shows how
the response of domestic prices to domestic wages varies with respect to changes in theshare of foreign products, this time for di¤erent/given values of  . In the …rst panel, theresponse of prices to wages is smaller as the share of foreign …rms increases. The reduction
is larger the higher is the degree of concentration in the sector captured by 1. On thecontrary, the right-hand side panel shows a bell-shaped response. When there are only
domestic …rms in the domestic market, , the response of domestic prices to a wage
shock is unitary. This is also the case when the share of foreign …rms is large and, mostimportant, when the degree of concentration in the market is very small, since  goesto in…nity. For intermediate values, the response is less than unitary. Overall two main
conclusions arise. Globalization reduces the response of domestic prices to movements indomestic marginal costs when foreign …rms enter the market to replace domestic …rms
without changing the overall degree of concentration in the sector. When the entrance of
foreign …rms increases the total number of …rms in the domestic market, hence increasing
the degree of competition, things are more complex. When a small number of foreign …rms
enter the domestic market, domestic prices become less sensitive to domestic conditions.
However as the number of foreign …rms becomes large, domestic prices become again
highly connected to domestic marginal costs, since domestic …rms are small.

5

Sticky prices

In this section, we study the implications of adding price rigidities through a cost of
adjusting prices as in the model of Rotemberg [33].5 There are three main implications
5

Alternative models of price-setting decisions, as for example Calvo [10], could have been considered.

10

of the new environment. It is now possible to study the interaction between sticky prices
and pricing competition in characterizing the degree of exchange-rate pass-through, thesensitivity of prices to movements in the marginal costs and the deviations from thelaw-of-one-price.6 Moreover, the presence of price rigidities allows to disentangle shortrun versus long-run e¤ects of marginal-cost shocks into prices, in line with the empiricalevidence. Finally, it is possible to derive a New-Keynesian Phillips curve linking in‡ation,
marginal costs and the additional elements implied by our model. The Phillips curve canbe compared with the traditional one and those developed by Bilbiie et al. [5], Cecioni [13],
Guerrieri et al. [25] and Sbordone [36] who also explore di¤erent aspects of globalization.
Such a comparison highlights the di¤erent implications of our model of strategic pricing
with respect to the ones present in previous literature.
In our model a generic …rm , based in country , producing in a generic sector  ofmarket  maximizes the present discounted value of pro…ts:


1
X
 =



·


 
  ¡ ¡ (¡ 1)2  
2  ¡1¸(15)

where , with  ¸ 0, is a parameter measuring the cost of adjusting prices, while is a nominal stochastic discount factor through which units of wealth are appropriately
evaluated across time and states of nature. The optimality condition requires prices tobe set as a time-varying mark-up over nominal marginal costs: = 
~ 





(16)

However, in this case, the mark-up is a more complicated expression and in particular isa function of past and future expected variations in prices as shown by~  =with:~ 
£¤(~  ¡ 1) 1 ¡ 2 (  ¡ 1)2 +   (  ¡ 1) ¡ ¡¡ ´ 

½

+1
+1  +1 ( +1 ¡ 1)


¾



(17)

(18)

and   ´  ¡1 ¡ 1.
To get further insights, we take a …rst-order approximation of (16) which delivers the
6

The interaction between sticky prices and pass-through has been emphasized by the recent empiricalevidence of Gopinath and Rigobon [23] and Gopinath and Itskhoki [22].

11following New-Keynesian Phillips curve:·¸¡ 1 ^
  =  ¢  +¢+   +1 ¹  

(19)^  ¡ ^ ¡ ^ ) andwhere we have de…ned the domestic real marginal costs as  ´ (the slope  is given by  ´ (¹ ¡ 1)
Compared to the traditional New-Keynesian Phillips curve, the one derived aboveis characterized by an additional element represented by the second addendum in thesquare bracket. This element captures the novel aspect of strategic pricing featured byour model. When …rms interact strategically, the aggregate supply equation shifts withthe movements in the mark-up which are driven by variation in …rms´ market share.
When  approaches in…nity, namely under a monopolistic-competitive market, or when
 =  the equation nests the traditional New-Keynesian Phillips curve.
Two elements di¤erentiate the Phillips curve of this model from the traditional one
and describe the in‡uence of globalization on the aggregate supply equation. The …rst
element is the slope of the curve, i.e. the short-run relationship between in‡ation anddomestic real marginal costs, which now depends on the number of products present in
the market. Indeed ¹ is an increasing function of  . The higher the number of products,
the higher is the steady-state elasticity of substitution and the higher is the response ofin‡ation to movements in the real marginal costs. Hence, from this point of view higher
competition steepens the Phillips curve and renders price more sensitive to domestic
shocks. In a closed-economy model with Kimball’s [30] preferences and monopolisticcompetition, Sbordone [36] also …nds that the slope of the curve is in‡uenced by the
number of varieties in the market, however in her case such relation might change direction
depending on parameters’ calibration.
The second element that characterizes equation (19) with respect to the traditional
New-Keynesian Phillips curve stems from the in‡uence exerted by the ‡uctuations inmarket share over the mark-up of domestic …rms. This in‡uence is captured by thesecond term in the square bracket of equation (19). The canonical open-economy model,such as the one in Benigno and Benigno [3], features an AS equation which is isomorphic
to the closed-economy equation:  = ~ ¢  +   +1(20)~ The open-economy dimension of the equation is hidden under thefor some parameter 
decomposition of the real marginal costs into a component given by the output gap and12another given by the terms of trade. In particular, foreign prices in‡uence the terms oftrade and then the real marginal cost. Woodford [39] has noticed that in this modelthe ‘global slack’ hypothesis might be contradicted. Indeed, for realistic calibrations, adecrease in foreign prices, improving the terms of trade, would raise the real marginal
costs and put upward pressure on prices instead of the downward pressure commonly
thought.7
Our model features an additional channel on top of the real marginal costs of equation(20) which results from variations in the market share for the domestic …rms, as shownin (19). Since the market share can be approximated by the relative prices^  = ( ¡ 1) (^ ¡ ^ )the Phillips curve can be written as follows:hi  =  ¢  +  (^ ¡ ^ ) +  +1 This shows the direct in‡uence of the relative prices on domestic in‡ation. Thise¤ect is akin to the channel studied by Guerrieri et al. [25], although in their model itarises assuming kinked demand as in Kimball [30]. On the contrary, in our model, it
depends more genuinely on primitive foundations based on …rms’ strategic interaction.
Those di¤erences allow us to interpret the primitive parameters of our model in thelight of the pro-competitive e¤ects typical of the globalization process. In particular,
the additional relative-price channel disappears under two circumstances. First, when all…rms become small in size ( goes to in…nity, implying  goes to zero); this nests the caseof a monopolistic-competitive market. Second, when the share of foreign …rms is small( goes to zero), or …nally in the particular case in which  =  implying also  that
goes to zero.8
Equation (19) can now be used to discuss the impact of globalization on the pricebehavior of …rms, namely on the slope and the shift of the aggregate supply equation.
Globalization, as captured by an increase in  , raises  and, for given   implies
an increase in the slope of the Phillips curve. Hence, on the one side, globalization
makes prices more sensitive to variations in the marginal costs as 
¹ increases. On theother side, in a globalized market domestic …rms compete for market share with foreign…rms, hence the relative market share, as proxied by the relative prices, shifts the AS
7

In the models of Bilbiie et al. [21] and Cencioni [13] the real marginal costs expressed in units of thegeneral price index is also a function of the total number of varieties produced in the economy.
8
In Guerrieri et al. [25] the additional relative-price channel disappears only when foreign products
disappear completely from the domestic market.

13equation for given domestic marginal costs. For instance, a fall in the foreign prices withrespect to the domestic prices reduces the market-share of domestic …rms and induces ade‡ationary pressure on domestic prices. Holding constant the size of the market, , anincrease in the share of foreign products reinforces this channel. Hence we conclude that
globalization, interpreted as an increase in competition from foreign …rms, renders theAS equation more dependent upon foreign conditions, namely foreign prices and foreign
marginal costs. Finally, let’s consider the case in which  rises with  (keeping 
constant). The e¤ect of  on the strength of the relative-price channel is less obvious.
At low values of   a further rise in the number of foreign …rms increases the importanceof the relative-price channel, whereas in markets, characterized by high competition offoreign …rms and low concentration, an increase in the number of foreign …rms abates
the relative-price channel. Eventually when  goes to in…nity, the relative-price channel
vanishes.

5.1

Exchange-rate pass-throughThe degree of exchange rate pass-through depends now on the interaction between pricestickiness and strategic pricing among …rms. To analyze this issue, we investigate theform of the Phillips curve implied by the optimality condition of foreign …rms selling in
the domestic market:
·
¸
1

¡

1
¤
¤
^
^  + ^ ¡ ^ ¡ ^ ) +  = ¤ (¹
 ¡ 1)(+   +1(21)
¹  
where ¤ measures the cost of price adjustment for foreign …rms and   ´ ln  ¡1 .
Equation (21) can be written as:(¹
 ¡ 1) ^(¹
 ¡ 1) ^ ¤ ^¡ 1 1 ^^ ¡ ^¡1 = ¡ +( +  ¡ ^¤ ) + +  (^+1 ¡ ^ )
¤
¤



¹  ¤ (22)
which is a di¤erence equation in ^ that can be solved for ^ taking as given the pathof wages, exchange rate and market share. The solution reads as follows:
·
¸
1
X
(¹

¡
1)

¡

1
1

¤
^
^ + + ^+ ) +^ = ^¡1 + 
()
(

¤
¤ +


¹


=0

(23)

where  is the stable root of the following polynomial:¸
1(¹
 ¡ 1)1 () =  ¡
+1+

+

¤

2

·

14

(24)

and in particular  increases with the degree of price rigidity, ¤ . Moreover, an increase in
the number of foreign …rms, competing in the domestic market, increases ¹ and decreases
.
Equation (23) shows that prices, set in country  by …rms producing in country 
depend on two components. A backward-looking component, which becomes more important when the degree of rigidity is higher and competition is lower, and a forward-looking
component. The latter depends on the present discounted value of the future marginal
costs and on the current and future evolution of the market share ^  .
Throughout we assume that the exchange rate follows a random walk. When holding
constant the evolution of the market share, our model nests the local-currency-pricing
model with sticky prices discussed by Benigno [2]. Indeed, in this case the short run
pass-through is given by: ^ (¹ ¡ 1)== 1 ¡ 1 ¡  ¤ ^
whereas the long-run pass-through is given by: ^1= 1
 ^The less than unitary short-run pass-through arises simply because prices are sticky,
even in absence of strategic competition. In particular the short-run pass-through issmaller, the higher the degree of rigidity. In the long run instead the pass-through is
unitary.
The classical local currency pricing market is only a limiting case of our model. In
general, movements in the market share can in‡uence pricing decisions. Expectations
play an important role in this context. If …rms expect large swings in market shares, theirpricing strategy is adjusted so that prices become less sensitive to shocks both, in thelong run and the short run. Recall, indeed, that the degree of market shares attains thefollowing representation:^  = ( ¡ 1) (^ ¡ ^ )
(25)
Consider an exchange rate depreciation. Foreign …rms do not change their prices, ^ 
one to one with the exchange rate as they incur in a reduction in their market share, ^  
as shown by equation (25). The degree of price rigidity also plays an important role inthis context. Indeed when stickiness of prices for their competitors is high, foreign …rms
will lose a larger fraction of market share when rising prices. This tends to dampen both,15

long run and short run pass-through. The analysis of the combined price dynamics inthe same destination market provides a quantitative assessment of the above mentionede¤ect.
Let us start with a simple case, for which analytical solutions are possible. We assume
that foreign …rms, selling in the domestic market, do not face cost of adjusting prices,while domestic …rms do so. The price rigidity faced by the competitors is su¢cient tocreate a dynamic adjustment, also in the prices of foreign …rms. Indeed, the price set by
the foreign …rm evolves according to equation (12), while the aggregate-supply equationof domestic …rms can be written as follows:(¹ ¡ 1) ^(¹
 ¡ 1) ^(¹
 ¡ 1) ^^ ¡^¡1 = ¡ +( ¡^ )+( ¡^ )+ (^+1 ¡^ )



(26)
Substituting (12) into (26) it is possible to obtain:(¹
 ¡ 1) 1 +  ^(¹
 ¡ 1) ^^ ¡ ^¡1 = ¡ +( ¡ ^ ) 1 + (¹
 ¡ 1) ^ ¤ + ^ ¡ ^ ) +  (^+1 ¡ ^ )
+(
 1 +  
which is a second-order di¤erence equation whose solution takes the following form:
·
¸
1
X
(¹

¡
1)



¤
^ + ¡ ^+ ) +^ + + ^+ ¡ ^+ ) ^ = 1 ^¡1 +1(1 ) (
(

1
+


=0
where 1 is the stable root of the following polynomial (1 ) = 21 ¡

·

¸
1
(¹
 ¡ 1) 1 + 
1+1+
1 + 

 1 + Once again the stable root, 1  is in‡uenced by the degree of price rigidity. The higher
the degree of price rigidity for the domestic …rms, the higher is the root 1 . Interestingly
now 1 decreases when the shares of foreign …rms in the domestic market increases. Indeed
in this case  falls and reduces 1 . Under the assumption that all exogenous processes
follow a random-walk, the above equation can be simpli…ed as follows:·¸
1 +  ^ ^ ¤ ^^^^^ = 1 ¡1 + (1 ¡ 1 )( ¡  ) +( +  ¡  ) 
1+
1+ 

(27)

Equation (27) shows that prices of the domestic …rms depend upon past prices andon a weighted average of domestic and foreign marginal costs. Notice that the terms in16

the square brackets measure the prices that would prevail under ‡exible prices.
Using these results and equation (12), we can then get the short-run pass-through of
exchange-rate movements into prices as: ^
1 
=+ (1 ¡ 1 )

1 + 
1 +  1 + 
 ^

(28)

whereas the long-run pass-through coincides with the long-run pass-through under‡exible prices: ^1
1 + 
=

(29)
1+
 ^
Even if foreign …rms have ‡exible prices, the short-run response of prices is below
the long-run response since domestic competitors face price rigidity. Price stickiness ofdomestic …rms dampens the short-run response of foreign prices to the exchange rate. The
higher is the degree of price rigidity in the domestic market, the smaller is the exchangerate pass-through. An increase in the number of foreign …rms selling in the domestic
market implies larger short-run and long-run pass-through.
Another case which allows us to obtain analytical solution and which deserves discussion is the one in which domestic and foreign …rms, selling in market  face the same
degree of nominal rigidities, i.e. ¤ =  The aggregate supply equation (21) of …rms
based in country  and selling in country  can now be written as follows:(¹ ¡ 1) ^(¹
 ¡ 1) ^ ¤ ^ ^¤ (¹ ¡ 1) ^^ ¡^¡1 = ¡ +( + ¡ )+( ¡^ )+ (^+1 ¡^ )
¤
¤


¤
(30)
Combining equations (26) and (30) implies the following evolution for relative prices: ¡  ¡1 =(1 ¡ 
¹ )(1 + )(¹
 ¡ 1) ^ ¤ ^^  + ^ ¡ ^¤ ) +  ( +1 ¡   ) (31) ¡( +  ¡ where we have de…ned:  = (^ ¡ ^ )
A solution to the di¤erence equation (31) delivers the evolution of the relative prices asa function of past relative prices and the current relative unit labor costs across countries:  =  ¡1 ¡(1 ¡ ) ^ ¤ ^^  + ^ ¡ ^¤ )
( +  ¡ (1 + ) (32)

where  is the stable root associated with the equation (31).
Substituting equation (32) into (30) gives the equilibrium prices for foreign …rms selling17

in the domestic market:^ ¤ + ^ ¡ ^¤ ) ¡^ = ( + )^¡1 ¡  ^¡2 + (1 ¡ )(1 ¡ )(^ ¤ + ^ ¡ ^  + ^ ¡ ^¤ )¡(1 ¡ )(1 ¡ )(
(1 + ) (33)

Notice that the above equation captures the full e¤ect of exchange rates into prices, as
it also captures the indirect e¤ects exerted through the movements in the market share.
The short run response of prices, set by foreign …rms in the domestic market, to exchange
rate ‡uctuations (the short-run pass-through) is given by:·¸ ^
= (1 ¡ ) 1 ¡ (1 ¡ )
(1 + )
 ^

(34)

while the long-run pass-through is: ^1
1 + 
=

1+
 ^
Once again the short-run pass-through is smaller than the long-run pass-through andis dampened by the degree of price rigidity. Interestingly, when prices are sticky for both
domestic and foreign …rms, the exchange-rate pass-through does not necessarily increases
monotonically as the horizon increases. Indeed the impact at medium horizons can bemuch smaller than the short-run impact.
In what follows we evaluate our results through some simulations. In particular we set
the elasticity of substitution across sectors to be  = 15 while that across goods withina sector such that  = 6 implying that the elasticity is higher within a sector than acrosssectors. The discount factor  is calibrated to imply, in a quarterly model, an average real
rate of 4% Therefore we set  = 099. The calibration of the price stickiness parameter, (or ¤ ) is performed so as to map the slope of the Phillips curve to that of a standard
model a´ la Calvo [10], in which  represents the probability of holding prices …xed and1(1 ¡ ) is the average duration of prices. In particular we use the following relationships
=



=

(¹
 ¡ 1)(1 ¡ )(1 ¡ )(35)

We calibrate the degree of price rigidity for the …rms based in the home country to
imply a duration of prices equal to three quarters, so that  = 066, and we derive theappropriate  using the above formula. In Figure 3, we plot the degree of exchange-ratepass-through as a function of the degree of price rigidity for the foreign …rms, ¤ , which18

is connected to ¤ through a mapping similar to (35). On the left panel of the …gure, we…x  = 05 and we present how the exchange-rate pass-through varies for di¤erent sizesof the sector, i.e. for di¤erent  . In the middle panel, instead we …x  = 10 and present
results for di¤erent  . On the right panel, we …x the number of domestic …rms  = 5
and present results for di¤erent  and so di¤erent  .
The degree of pass-through is decreasing when price rigidity of foreign …rms increases.
The left panel shows that, for a …xed level of rigidity, the higher the concentration in
the industry the lower is the pass-through, but also that, when rigidity increases, theconcentration in the industry has a smaller impact on the degree of pass-through. The
middle and the right panels show similar pictures, although now the degree of pass-throughis reduced when the share of foreign products is low. We conclude that globalization might
increase the degree of pass-through, for given degree of nominal rigidity, the more so thelower the degree of rigidity.
Figure 4 shows the impulse response of foreign prices to an exchange-rate shock fordi¤erent degrees of nominal rigidities (for the foreign …rms). We set  = 066,  = 10
and  = 05. The convergence to the long-run is faster the higher the degree of price‡exibility. Interestingly, after 10 quarters, the pass-through is still far from the long-run
pass-through for reasonable degrees of rigidity.

5.2

Response of domestic prices to domestic conditions

We now investigate how the interaction between price stickiness and strategic pricinga¤ects the response of domestic prices to domestic marginal costs and how this relationshipdepends on globalization. We can get some insights on this issue by using some of theexamples of the previous section. Recall that we have derived the price set by the domestic…rms in market  as:·¸
1 +  ^ ^ ¤ ^^^^^ = 1 ¡1 + (1 ¡ 1 )( ¡  ) +( +  ¡  ) 
1+
1+ 
assuming that foreign …rms face ‡exible prices. Domestic prices depend on the past
domestic prices and on a weighted average on domestic and foreign marginal costs. The‘global slack’ hypothesis is well formalized in the above equation. Foreign marginal costsa¤ect domestic prices more when the share of foreign products in the market increases(for given size of the market). In this case, the short-run response of domestic prices to19

movements in wages is given by: ^
1 + 
= (1 ¡ 1 )
^
1+

which is, unambiguously, decreasing with the increase in the share of foreign …rms inmarket  since:
1 + 
1 (¹ ¡ 1)(1 ¡ 1 )=1+
1 ¡ 1 
and since 1 decreases as  increases. Clearly, also the long-run response of domestic
prices does not rise proportionally to the increase in domestic marginal cost due to thestrategic competition with foreign …rms. Indeed the long run pass-through is lower thanone: ^1
1 + 
=
1
^
1+
 
unless  = 1 or  = 0 (when  ! 1) The response of domestic prices to domestic
marginal costs increases monotonically from the short to the long run. But, it is su¢cient to introduce some rigidity in the prices of foreign …rms to induce a non-monotonic
adjustment across time. Actually, the response of prices to wages can be dampened for along period of time because of the strategic interaction with foreign …rms featuring sticky
prices.
Figure 5 plots the response of prices to a wage shock, as a function of the degree of
price rigidity faced by foreign …rms, ¤ . On the left panel of the …gure, we …x  = 05
and show how the response of prices to a wage shock varies for di¤erent  . In the middle
panel, instead we …x  = 10 and show results for di¤erent  . On the right panel, we …x
the number of domestic …rms,  = 5 and present results for di¤erent   hence di¤erent.
The left panel of …gure 5 shows that the response of prices to movements in domestic
marginal costs is smaller the higher the degree of price rigidity, but is relatively smaller insectors characterized by higher concentration, since competition is stronger. The middle
panel shows a similar picture, however now the response of prices to domestic conditions is
reduced when the share of foreign products in the market increases. Globalization should
therefore reduce the response of prices to domestic conditions, the more so the lower isthe degree of rigidity. This is always true when we …x the total number of …rms in themarket. On the contrary, when we …x the number of domestic products in the market,
and let the foreign products enter the market freely, we get an ambiguous result as for the‡exible-price model. When starting from a small share of foreign products in the market,
a further increase in the number of foreign products lowers the response of domestic price20

to domestic conditions. Instead, when starting from a large share of foreign products, anincrease in foreign products reduces the degree of concentration in the industry up to thepoint that the response of domestic prices to domestic conditions becomes unitary.

6

Empirical analysis

Our empirical analysis is divided into two parts. In the …rst part, we explore the consequences of globalization on the degree of exchange rate pass-through by highlighting
the role of international competition. In the second part, we stress the importance of
globalization for the dynamic of domestic in‡ation.

6.1

Globalization and exchange rate pass-throughIn our model globalization increases the degree of exchange rate pass-through. In particular the degree of exchange rate pass-through depends on the degree of concentration in themarket and on the share of foreign products competing in the domestic market. Greater
competition, due to an increase in the foreign products sold in a particular industry, rises
the exchange rate pass-through both, in the short and the long run.
To test this channel we use data for …ve manufacturing sectors in the US: 1) vegetables
and prepared food, 2) leather and footwear, 3) textiles and textile articles, 4) vehicles,
vessels and associated transport equipment, and 5) base metals and machinery. Data arequarterly from 1993 to 2008. A more detailed description of the dataset can be found in
Appendix A. We run several multiple regression analyses on both the entire sample andthe sub-samples to identify the e¤ects of the increased globalization.
Figure 6 shows industry-speci…c real exchange rates and nominal import prices forthe …ve sectors and the period 1993-2008. Industry-speci…c real exchange rates are from
Linda Goldberg’s database while nominal import prices refer to the log of import prices,for each sector. Visual inspection shows that in the last part of the sample there arestronger co-movements between the two series, and this is particularly true for Sectors
1,2, 3 and 5. Some simple computations in Table 1 show, indeed, that in the …rst part ofthe sample prices vary in the opposite direction with respect to the real exchange rate,
except for Sector 5. On the contrary, in the last eight years, the cumulative price change
is more in line with the cumulative real exchange rate change.
To test the hypothesis of stronger co-movements over the most recent sample, we run

21seemingly unrelated regressions on a model with the following speci…cation:¢ =  +X  ¢¡ + 

(36)

=0

where ¢ represents the change in log nominal import price of a generic sector at time  and ¢ represents the change in the real exchange rate for sector ,  is a
generic constant, and   is the sector-speci…c coe¢cient measuring the response of prices
to real exchange rate movements at lag .9 With the SURE estimator, we are allowing
the unobserved shocks  to co-vary across the di¤erent sectors. The speci…cation ofequation (36) is similar to that of Gopinath and Itskhoki [23], who analyze data at thelevel of disaggregated US import prices. Contrary to us, Gopinath and Itskhoki [23]de‡ate the import price with the CPI in‡ation rate. We instead consider the sectorial
real exchange rate as a good proxy for the sectorial nominal exchange rate and therefore
analyze the pass-through into nominal import prices.
To make our measure of pass-through comparable to the one considered in the literatP
ure we de…ne it as the sum of the coe¢cients 
=0    for each sector  This measure
also corresponds to the long run pass-through de…ned in our model. We also consider analternative linear speci…cation, which includes a dependence on lag prices changes, in linewith the assumptions made in our theoretical model with sticky prices:¢ =  +   ¢¡1 +
X

  ¢¡ +  

(37)

=0

In the speci…cation above the coe¢cient   measures the persistence of import-pricePchanges. In this second case we de…ne pass-through with the term 
=0   (1 ¡   )We have repeated estimation for the parameters in (36) and (37) over di¤erent subsamples In particular, we have chosen the …rst quarter of 2001 as the date for splitting
our time sample into two sub-samples. Such choice is motivated by the observation of theevolution of an indicator of market competition and a proxy for globalization. We takethe Her…ndahl-Herschmann index as a proxy for the degree of market concentration (seeAppendix A for details), while we take the share of import from China on total import ineach sector as a proxy for the share of foreign products in the domestic markets Table 3
presents the Her…ndahl-Herschmann index for the sectors under consideration and showsthat competition has increased (a fall in the HH index) signi…cantly for Sectors 2 and 4
and decreased for the other sectors. Figure 9 shows that the share of imports from China
9

We set  = 3, since longer lags are not signi…cant.

22

has increased steadily in each of the sectors considered and at a faster pace after 2000.
This observation is consistent with our choice of the year 2000 as the break point. We
consider, indeed, the series of Chinese imports into the US as proxy for the degree ofmarket penetration of foreign …rms into the US market.10
Finally, we have considered the following alternative speci…cations for computing theprice increments: quarterly di¤erence indicated as ¢   yearly di¤erence indicated as¢  and two-year di¤erences indicated as ¢2   In particular the regressions on oneyear and two-year di¤erences aim to give an alternative computation for the pass-through.
Results are shown in Table 2.
For Model (A), which is based on equation (36), results in Table 2 show, almost consistently across all sectors, that the pass-through has increased over the second sub-sample(after 2001). In particular the pass-through has increased in all sectors except textile, forwhich however the degree of pass-through is quite small. All estimated coe¢cients are
signi…cant at 95% con…dence interval. Finally notice that results are con…rmed when
considering model (B), represented by equation (37), and model (C) and (D) which use
data based, respectively, on one- and two-year di¤erences.
To further investigate how the degree of pass-through has changed over time, we haverepeated the above regressions (for the quarterly di¤erence) on a 8-year rolling window.
Results are shown in Figure 7 for model (36) and in Figure 8 for model (37). Figure 7
shows clearly that the pass-through has increased for all sectors if the estimation window
includes the last part of the sample. Figure 8 presents a similar pattern for Model (B).
Our results con…rm some of the previous results in the literature on exchange ratepass-through, but also add some novel dimensions. Earlier papers …nd evidence of partial
pass-through, hence rejecting both producer currency pricing and local currency pricing
as characterizations of aggregate behavior (see Campa and Goldberg [11] for an empiricalanalysis on OECD countries and Bugamelli and Tedeschi [8] for evidence on euro area
countries). More recent studies (see Campa and Goldberg [12]) have found that the passthrough has declined in the past decades for most countries except the United States.
Our paper shows that the most recent years contribute to a signi…cant increase in the
pass-through for some sectors and that this e¤ect can be attributed to the process ofglobalization.
10

Bugamelli et al. [9] shows that the increase in the share of imports from China explains the dynamicof domestic prices for several countries.

23

6.2

Globalization and AS equation

The second empirical implication of our model refers to the AS equation, which is now
augmented by the relative-price channel:hi^^  =  ¢  +  ( ¡  ) +  +1 (38)

Two main features characterize the new AS equation. First, the global slack component, represented by the term  (^ ¡ ^ ) plays a signi…cant role. Second, the slopeof the Phillips curve, represented by the parameter , depends on the goods-market competition and therefore can change with the globalization process. By estimating equation(38), we aim to provide support for our theoretical results. There are several estimation
methods to test the AS equation (38).11 We follow the one in Sbordone [35]. We write
the AS equation as follows:^ ¡ ^¡1 = ( ¡ ^ ) +  ¢  +  (^+1 ¡ ^ )where we de…ne  ´ ( ¡ ^ )  as unit labor costs, and the relative prices  as ´ (^ ¡ ^ ). The above equation is solved forward with respect to ^ to obtain:^ = 1 ^¡1 + (1 ¡ 1 )(1 ¡ ¡1
2 )

(1
X
 =

)

¡( ¡)2[ +  ¢  ](39)

where 1 is given by:

1 =

1+

¡1

+ 

¡1

¡

q

(1 +  ¡1 +  ¡1 )2 ¡ 4 ¡1
2and 2 = (1 )¡1 . The next step is to rearrange equation (39) as follows:(1)
X(^ ¡  ) = 1 (^¡1 ¡ ¡1 ) ¡ ¢ + (1 ¡ 1 )
(1 )( ¡) [¢ +  ¢  ] 
 =

(40)

where  ´  
Equation (40) allows to test the relation between the log di¤erence of domestic prices
on one side and unit labor costs, their lags, their future expectations and relative prices
on the other. This relation depends on the parameters 1 and  which are in turn related
to the deep parameters of the model. In particular the parameter 1 depends upon 
11

For an alternative strategy in terms of GMM estimation see Galí and Gertler ([20]).

24

the slope of the Phillips curve, and  the discount factor, while the parameter  depends
upon  and   which are proxies for the market share. Since it is not possible to identify
separately the parameters  and  , as well as the parameters  and , we focus on
identifying the slope of the AS equation, , and the parameter, . The latter is a crucial
parameter as it captures the importance of the relative-price channel as emphasized byour model. Moreover assuming that  = 099, as it is standard in a quarterly model, we
can identify .
To evaluate the right-hand-side of (40), we need to compute expectations of futurechanges in the unit labor costs and future relative prices. To this end, we use a VAR
model with two lags involving the following vector of variables  = [(^ ¡  ) ¢ ] Therefore for a combination of parameters  and  we can get the model implied
log-di¤erence between prices and unit-labor costs. To estimate  and , we search for thePvalues that minimize the criterion =1 2  where  measures the distance between themodel implied (^ ¡  ) and the data. In particular we run a grid-search analysis forthe parameters  and  under the non-negative constraints.
We estimate equation (38) on two di¤erent datasets and di¤erent samples. On the one
side, we use data on prices and unit labor costs for the non-farm business sector which has
been traditionally the focus of analysis to test closed-economy New-Keynesian AS curves.
On the other side, we use data on prices and unit-labor cost for the manufacturing sector.
Data for the latter sector have never been used before in tests of the New-KeynesianPhillips curve, although they are particularly relevant for our experiment as this sector
has been heavily exposed to the globalization process in the last decade.
Figure (10) plots the log of prices and unit labor costs for the two sectors analyzed
together with the appropriate relative price, de…ned as the log of the price of importwith respect to the domestic price. The import-price index is constructed by aggregating
sectorial manufacturing import-price indexes, as discussed in the appendix. Such aggregation is possible only for the period 1993-2008. To appreciate the di¤erence between thetwo sectors in terms of their exposure to globalization, Figure (10) is illustrative. In the
non-farm business sector there is a strong relationship between prices and unit labor costs.
This is not the case in the manufacturing sector, where unit labor costs have decreased in
the past decades but the prices have instead increased. However, in this sector, prices are
positively correlated with the relative price, therefore with the import prices, suggestingthat international competition might be an important aspect in‡uencing the dynamic ofdomestic prices.
When computing Phillips curve estimations we perform the following comparison: forboth sectors we compare estimation of the traditional Phillips-curve equation, in which25the parameter  is set to 0 to shut o¤ the relative-price channel, with the estimation of thespeci…cation implied by our model. Table (4) summarizes the results of the estimation ofequation (38) for the full sample 1993-2008, the …rst part of the sample 1993-2000 and thelast part of the sample 2001-2008. Focusing …rst on the full sample and on the benchmark
case of the traditional AS equation ( = 0) we obtain an estimate of  equal to 0.01 for the
non-farm business sector, which implies a high value of price rigidity, close to 10 quarters,
in a model with a common labor market, but a value consistent with other estimates ofthe literature when we considered …rm-speci…c labor market, around 4 quarters.12 These
results are in line with those of Sbordone ([35]) which covers a di¤erent sample, however
the estimated coe¢cient is not signi…cantly di¤erent from zero. This is not surprising as
it is in line with the comments made in Fuhrer ([19]) on the di¢culties of identifying the
New-Keynesian Phillips curve. We then repeat the same restricted ( = 0) estimation forthe manufacturing sector on the full sample. Here we get the following estimates:  = 0
and then 1 = 1 This result con…rms the visual inspection obtained through Figure(10). A value for  equal to zero in (40) implies that the lagged price performs better,based on our estimation criterion, in …tting the current price. Moreover this shows that
equation (38) cannot be longer interpreted as the appropriate Phillips curve, as discussed
also in Fuhrer ([19]). Therefore the traditional AS equation does not …t well data for the
manufacturing sector.
We then move to the unrestricted estimation on the full sample and allow for the
relative-price channel ( 6= 0). We …nd that such channel is important for both sectors andin particular for the manufacturing sector. Now, the slope of the AS equation increases
to 0.015 for the manufacturing sector and to 0.078 for the non-farm business sector.
Most important the point estimate of  is positive in both sectors and greater in the
manufacturing sector. In the latter case it is also signi…cant. Interestingly, in the second
part of the sample, after the 2001, signi…cance increases for both the manufacturing sector
and the non-farm business sector, while in the …rst part of the sample all the coe¢cients
perform poorly for both sectors.
These results support the importance of the relative-price channel in explaining the
dynamic of prices. This is true mostly for the second part of the sample when globalization
plays a major role. Moreover such results explain why estimations of the traditional NewKeynesian AS equation performs poorly so often. Notice, indeed, that we …nd a 55%
P
reduction in the criterion =1 2  when we allow for a non-zero  in the estimation of
the AS equation, for both sectors.
12

With a …rm-speci…c labor market  in (35) should be multiplied by the factor (1 + ¹) where  is theinverse of the Frisch elasticity of labor supply.

26

Our results are in line with the ones obtained by Guerrieri et al. [25] which, by comparing an unrestricted and a restricted speci…cation for the AS, also …nd evidence that
foreign competition plays an important role in accounting for the behavior of in‡ation in
the traded-goods sector. However, besides some di¤erences in the estimation strategy, ourresults di¤er critically both in terms of the micro-foundations chosen to explain the globalization phenomenon and in terms of the dataset chosen for the estimation. We believe
indeed that trade globalization is better captured by a model of oligopolistic competition
between domestic and foreign …rms and that the manufacturing sector is the more exposedto this phenomenon.

7

Conclusions

Much discussion has been devoted in recent years over the e¤ects of globalization. While
the globalization process takes di¤erent forms, we focus on one particular aspect whichis the surge in the fraction of …rms selling abroad. Competition in international market
renders the pricing decision of …rms more dependent upon foreign factors, hence reduces
the dependence of in‡ation on the domestic slack. Such increased link between domestic
in‡ation and global factors occurs through two main channels: …rst, an increase in theimpact of import prices on the overall price index due to an increase in the number offoreign products in domestic markets; second, an increase in the dependence of the pricing
strategies of domestic …rms on foreign components, due to the increase in competition withforeign …rms. Interestingly the reduced form of the Phillips curve changes by shifting withrelative-price movements and the sensitivity of in‡ation to marginal costs changes with
globalization. Moreover, as far as …rms’ pricing decisions are a¤ected by the relative
market shares between domestic and foreign …rms competing in the same destination
market, the degree of exchange rate pass-through rises with an increase in the number offoreign competitors. Our theoretical results are con…rmed through an empirical analysis
based on manufacturing sectors in the US. Indeed there is evidence of an increase in the
degrees of pass-through in most of the sectors considered. Moreover, estimation of theAS equation for the manufacturing sector provides evidence for the importance of therelative-price channel in accounting for the dynamic of in‡ation as emphasized by ourmodel.
The dependence of in‡ation upon global factors might have important implications
for the conduct of monetary policy as it might reduce the leverage that central bankers
have in controlling prices, a topic, the latter, that we leave for future research.

27

8

Appendix: Data

Pass-through analysis
The data used have quarterly frequency on the sample 1993q1-2008q4.
Industry-speci…c real exchange rate data are taken from Linda Goldberg web site.
They correspond to the series “merman” of the Industry-speci…c exchange rate database.
The index used is a multilateral exchange rate index elaborated by Linda Goldberg from
United States International Trade Commission (USITC) import data.
Sectorial import prices data are taken from Bureau of Labor Statistics (BLS) web siteand correspond to the Harmonize System Import Index. The index is an industry-speci…cmultilateral import price following the one digit Harmonized System classi…cation (HS).
The original series have monthly frequency, hence, in order to obtain a quarterly series
the average value of three months for each quarter has been considered.
Data on sectorial import prices and sectorial import exchange rate have been aggregated into 5 sectors using the Relative Importance Index of Table 3 and 5 from thehistorical tables of U.S. Import and Export Price Indexes of BLS . The following sectors
are considered:
Sectors

HS sectors

NAICS sectors

Vegetables and prepared food

II – IV
VIII – XII
XI
XVII
XV – XVI

311 – 312316
313 – 314
336
331 – 332 – 333 – 334 – 335

Leather and footwear
Textiles and textile articles
Vehicles, vessels and transport equipment
Base metals and machinery

In this way the variables  and  were obtained. While the variables ¢ and ¢are the log-di¤erence of the respective series.
Sectorial index of concentration data are taken from Economic Census: Concentration
ratios, years 1997 and 2002 . In particular the Her…ndahl-Herschmann index for 50 largest
companies from the Economic Census has been used. Data are available, for each three
digits NAICS sector, only for years 1997 and 2002.
Data on sectorial import share from China are taken from United States International
Trade Commission (USITC) web site. For each sector, to obtain Chinese import share,
sectorial imports from China were divided by sectorial total imports. Sectorial imports
correspond to “custom-value” series.
Aggregate-Supply analysis
28

The data for prices and unit labor costs for the manufacturing sector and non-farmbusiness sector are from BLS and available on a quarterly basis. Sectorial import prices
data are taken from Bureau of Labor Statistics (BLS) web site and correspond to theHarmonize System Import Index. The index is an industry-speci…c multilateral importprice following the one digit Harmonized System classi…cation (HS). The original series
have monthly frequency, hence, in order to obtain a quarterly series the average value of
three months for each quarter has been considered. Data on sectorial import prices havebeen aggregated into a single import price using the Relative Importance Index of Table
3 and 5 from the historical tables of U.S. Import and Export Price Indexes of BLS .

29

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[37] Soto Claudio and Jorge Selaive, 2003. “Openess and Imperfect Pass-Through: Implications for the Monetary Policy,” Banco Central de Chile, W.P. N± 216.
32

[38] Rotemberg, Julio, and Michael Woodford, 1995. “Dynamic General Equilibrium
Models with Imperfectly Competitive Product Markets,” Ch. 9 of Thomas Cooley,ed., Frontiers of Business Cycle Research, Princeton University Press.
[39] Woodford Michael, 2007. “Globalization and Monetary Control,”.NBER Working
Paper No. 13329.

33Sector 1 Sector 2 Sector 3 Sector 4 Sector 5
1993 ¡ 2000

-0.30

-0.19

-0.10

-0.59

0.77

2001 ¡ 2008

2.35

0.57

0.26

1.05

0.59

Table 1: Ratio between the log-change in import price and the log-change in the realexchange rate (¢¢) computed on the intervals 1993-2000 and 2001-2008 for the …ve
sectors considered: 1) vegetables and prepared food, 2) leather and footwear, 3) textiles
and textile articles, 4) vehicles, vessels and associated transport equipment, and 5) basemetals and machinery.

Sector 1¤¤¤
Model (A)
0.497
Until 2001 Q1 0.259
After 2001 Q1 0.483¤¤
¤¤

0.201
¤¤¤
0.147
¤¤¤
0.288

¤¤¤

0.154
¤¤¤
0.164

Model (B)
0.540
Until 2001 Q1 0.168
After 2001 Q1 0.560
Model (C)Model (D)Sector 2
¤¤¤
0.192
¤¤¤
0.158
¤¤¤
0.290

0.409
¤¤¤
0.554

Sector 3
¤¤
0.081
¤¤
0.124
0.059

¤¤¤

0.083
0.115
0.042

¤¤¤

0.076
¤¤¤
0.095

Sector 4¤¤¤
0.130
0.153¤¤¤¤¤
0.159

Sector 5
¤¤¤
0.669
¤¤¤
0.631
¤¤¤
0.645

¤

0.080
0.108¤
0.103¤¤¤¤¤

0.711
0.840¤
¤¤¤
0.699

¤¤¤

¤¤¤

0.086
¤¤¤
0.087

¤¤¤

0.439
¤¤¤
0.630

¤¤¤

Table 2: Estimated pass-through coe¢cients for Sector 1 (vegetables and prepared food), Sector
2 (leather and footwear), Sector 3 (textiles and textile articles). Model (A) corresponds toequation ( 36), Model (B) corresponds to equation (37). Model (C) to the following equation¢  =  +  0 ¢  +  where ¢ represents the one-year di¤erence operator. Model (D)corresponds to the following equation ¢2  =  +  0 ¢2  +  where ¢2 represents thetwo-year di¤erence operator. Stars denote signi…cance level, ¤¤¤ =1%, ¤¤ =5%, ¤ =10%.

Sector 1 Sector 2 Sector 3 Sector 4 Sector 5
1997 219.28

167.2

115.13

797.6

85.41

2002 229.22

163.6

185.48

526.9

92.15

Table 3: Her…ndahl-Herschmann index of market concentration for the …ve sectors considered: 1) vegetables and prepared food, 2) leather and footwear, 3) textiles and textile
articles, 4) vehicles, vessels and associated transport equipment, and 5) base metals andmachinery.

34

Manufacturing sector
(1)
(2)



0000



0



(0024)0001(00116)



0



0002



(00275)

0Non-farm business sector(3)(4)

Full Sample 1993-2008
0025
0010
(0069)(0048)032¤

0(019)

Sample 1993-2000
0001
0024

(00202)(00471)025

0(421)

Sample 2001-2008
01
002

(02429)(01098)037¤¤

0(01507)0057(0131)004(0032)0019(00523)005(0148)0087(02969)

005¤(00295)

Table 4: Estimates of  and  in equation (38) for the manufacturing and non-farmbusiness sector. In columns (1) and (3)  is restricted to be equal to zero. Data arequarterly. Three di¤erent samples are considered: 1993-2008, 1993-2000, 2001-2008.

35

1

1

0.95

0.95

f

P

P

f

0.9

0.85
0.9
N =4
h

0.8

0.75

N =5

N=4
N=5
N=10
N=50
N=100
0

0.2

0.4

0.6
s

0.8

h

N =10
h

N =50
h

N =100
h

0.85

1

0

0.2

0.4

0.6
s

f

0.8

1

f

Figure 1: Long-run pass-through ( ^  ^ ) as a function of the share of foreign productsin the domestic market,  . On the left panel,  is …xed (at di¤erent levels) and  isvaried from 0 to 1. On the right panel,  is …xed (at di¤erent levels) and  varies from0 to in…nity to imply variation in  .

1

1.005

1
0.95

0.995

0.99
0.9
h

P

P

h

0.985

0.98
0.85
0.975
N =4

0.75

h

0.97

0.8

N=4
N=5
N=10
N=50
N=100
0

0.2

N =5
h

N =10
h

0.965

N =50
h

N =100
h

0.4

0.6
s

0.8

0.96

1

0

0.2

0.4

0.6
s

f

0.8

1

f

^  ) as a funcFigure 2: Long-run response of domestic prices to domestic wages ( ^  tion of the share of foreign products in the domestic market,  . On the left panel,  is…xed (at di¤erent levels) and  is varied from 0 to 1. On the right panel,  is …xed (atdi¤erent levels) and  varies from 0 to in…nity to imply variation in  .

36

0.9

0.9

0.9

0.8

0.8

0.8

0.7

0.7

0.7

0.6

0.6

0.6

0.5

Pf

1

f

1

P

f

P

1

0.5

0.4

0.4

0.3

0.3

0.5
0.4
0.3

s =0

s =0

f

0.2
0.1
0

0.2

N=4
N=5
N=10
N=50
N=100
0

f

s =0.2s =0.20.2

ff

s =0.5s =0.5ff

s =0.80.1

s =0.8

0.1

f

f

s =1

s =0.99

f

0.5
*

1

0

0

f

0.5
*

1

0

0

0.5
*

1

Figure 3: Short-run exchange-rate pass-through ( ^  ^ ) as a function of ¤  measuring
the degree of nominal rigidity of foreign …rms. On the left panel  is …xed at di¤erent
levels and  = 05 In the middle panel  is set at di¤erent levels and  = 10 On theright panel,  is also set at di¤erent levels while  = 5.

1
*=0.01*=0.5
*=0.66
*=0.75
*=0.80

0.9
0.8
0.7

P

f

0.6
0.5
0.4
0.3
0.2
0.1

0

5

10
time

15

20

Figure 4: Impulse response function of foreign prices,   to an unitary shock to thenominal exchange rate for di¤erent degress of nominal rigidities in the foreign economy,
¤ .
37

1

1
N=4
N=5
N=10
N=50
N=100

1
s =0

s =0

f

f

s =0.2s =0.2f0.9

s =0.5fs =0.8

f

f

s =1

0.7

0.7

0.7

0.6

0.6

0.6

0.5

0.5

0.4

0.4

0.3

0.3

0.3

0.2

0.2

0.2

0.1

0.1

0.1

0.4



0.6

0.8

0

1

0

0.2

0.4



0.6

0.8

0

1

f

0.5

0.4

0.2

s =0.99

0.8

f

Ph

h

0.8

0

s =0.5s =0.8

0.8

0

f

0.9

f

P

P

h

0.9

0

0.2

0.4



0.6

0.8

1

^  ) as a
Figure 5: Short-run sensitivity of domestic prices to domestic wages ( ^  
function of  measuring the degree of nominal rigidity of …rms based in country . On
the left panel  is …xed at di¤erent levels and  = 05 In the middle panel  is set
at di¤erent levels and  = 10 On the right panel,  is also set at di¤erent levels while = 5.

Food

Leather-4.5

6

Textiles

-4.4

4.7

-4.45

4.68

-4.5

4.66

-4.55

4.64

-4.6

4.62

-4.65

4.6

-4.7

4.58

-4.75

4.56

-4.8

4.54

-4.85
-5

4.5

-4.9

-4.4

4.7

-4.4

5

-4.5

4.65

-4.5

4.9

-4.6

4.6

-4.6

4.8

-4.7

4.55

-4.7

4.7

-4.8

4.5

-4.8

4.6

-4.9

4.45

-4.9

1998

2002

2006

1994

1998

Transportation

1994

1998

2002

4.7

-4.7

4.65

-4.8

4.6

4.52

4

1994

-4.6

2002

2006

-4.9

1994

1998

2002

2006

4.55

Metal

2006

1994

1998

2002

Exchange rate

2006

4.5

Import price

Figure 6: Plot of the logs of the real exchange rate and of the nominal import price forthe …ve sectors considered.

38

0.35

0.16
0.3

0.5

0.1

0.15
0.14

0.25

0.08
0.12

0.45

0.1

0.2

0.06
Pass-through

0.1
0.15
0.04
0.08

0.05

0.4

0.1
0.02

0.06
0.05
0

0.04

0

0.35

0
0.02
-0.02

-0.05

-0.05
0
0.3

-0.1
2000

2004

2008

2000

2004

2008

2000

2004

2008

-0.04
2000

2004

2008

2000

2004

2008

Figure 7: Pass-through for each of the …ve sectors considered, estimated using the model(36) on 8-year rolling window. For example, the values obtain in the year 2002 at the …rst
quarter corresponds to the estimation window 1994.Q1-2002.Q1.

0.2

0.1
0.55

0.35

0.18

0.3

0.08

0.16
0.15

0.5

0.25
0.14
0.06
0.2
0.1

Pass-through

0.12

0.45

0.15
0.04
0.1
0.1
0.05
0.05

0.08

0

0.06

0.02
0.4

0
0

-0.05

0.35

0.04
-0.02

-0.1
0.02
-0.15
2000

2004

2008

2000

-0.05
2004

2008

2000

2004

2008

2000

2004

2008

0.3
2000

2004

2008

Figure 8: Pass-through for each of the …ve sectors considered, estimated using the model(37) on 8-year rolling window. For example, the values obtain in the year 2002 at the …rst
quarter corresponds to the estimation window 1994.Q1-2002.Q1.

39

0.7

0.06

0.6

0.05

0.5
0.04
0.4
0.03
0.3
0.02
0.2

0.01

0.1

0
Q1 1993

Q1 1996

Q1 1999

Q1 2002

Sector 1

Sector 2

Sector 3

Q1 2005
Sector 4

Q1 2008

0

Sector 5

Figure 9: Import share from China for the …ve sectors considered: 1) vegetables andprepared food, 2) leather and footwear, 3) textiles and textile articles, 4) vehicles, vessels
and associated transport equipment, and 5) base metals and machinery. Sector 1 and 4plotted on a secondary axis.

Manufacturing Sector

Non-Farm Business Sector

0.35

0.3

0.5
Price
Unit labor cost
Relative Price

Price
Unit labor cost
Relative Price
0.4

0.25

0.3

0.2

0.15
0.2
0.1
0.1
0.05

0

0

-0.05
-0.1
-0.1

-0.15
Q4 1993 Q4 1996 Q4 1999 Q4 2002 Q4 2005 Q4 2008

-0.2
Q4 1993 Q4 1996 Q4 1999 Q4 2002 Q4 2005 Q4 2008

Figure 10: Plot of the price, unit labor cost and relative price for the manufacturingsector (left panel) and the non-farm business sector (right panel). All variables in logs
and demeaned.

40