Globalization, Pass-Through and In ation
Dynamic
Pierpaolo Benigno
LUISS

Ester Faia
Goethe UniversityMay 2010

Motivation
This paper investigates the \global-slack hypothesis", the extent towhich in ation is more in uenced by external conditions as a consequence of the globalization process.

Globalization expands world trade. The increasing presence of foreign
products in destination markets can change industry characteristics as
the degree of competition and market concentration. Pricing strategies
might be a ected and thus the in ation dynamic.

Two channels under investigation. How can globalization change...:1. ...the degree of pass-through, and therefore the sensitivity of prices ofimported goods to external conditions (exchange rate, foreign marginalcosts)?

2. ...the dynamic of domestic in ation, and therefore the sensitivity ofprices to domestic and foreign marginal costs?

Findings
Globalization should increase the degree of exchange-rate pass-through.
{ When the share of foreign rms in the domestic market increases,
foreign rms face less competition for market shares coming fromdomestic rms. Foreign rms dominate the market and can passthrough more easily their costs into prices.
{ When the index of concentration in the market becomes low because more foreign rms enter, all rms become small and therefore
behave as in a monopolistic-competitive market. Pass-through becomes unitary.
{ We nd empirical evidence to support these theoretical results.

Globalization steepens and shifts the Phillips curve.
{ An increase in the number of foreign rms in the market reduces
the concentration in the industry and the steady-state mark up
making prices more sensitive to domestic marginal costs.
{ The New-Keynesian Phillips curve is also in uenced by the relative
price (foreign-versus-domestic) on top of domestic real marginal
costs. Relative price is a proxy for the market share.
{ \Global-slack hypothesis": a reduction in foreign prices puts downward pressure on domestic prices and shifts downward the AS equation.
{ The \global-slack" component depends on the share of foreign
rms in the market and the degree of concentration in the industry.

ModelNatural model to think about globalization is one in which rms compete for market shares through their pricing decision. (Dornbusch,1987).

Monopolistic competition (with isoelastic demand) would not work.
Mark-ups are constant (in a ex-price model).

A model in which rms are not small with respect to the market
allows for time-varying mark-ups which depend on market shares andtherefore on the relative marginal costs across rms with di erent
technology or based in di erent markets.

Two-country model, with multiple sectors, indexed by k. N di erentiated goods in market h, Nh; produced by rms residing in h and Nf
by rms residing in f .

Optimal demand for a generic good i; in country h and sector k; is:PiYi = ( )PkPk( )
PY

whereis the elasticity of substitution among varieties in sector kand is the elasticity of substitution across sectors.
Pk = (NhX

i=1

Pi1+NfX

Pj1)1

1

j=1

where Pj denotes the price of a generic good j in the sector k, produced in country f .

Following Dornbusch (1987), we assume that rms are not small withrespect to their sector meaning that, in their pricing decisions, theyinternalize the fact that they can in uence the sectoral price.

The elasticity of demand of good i with respect to its price Pi is givenby@Yi Pi=@Pi Yi~i() iwhere i identi es the market share of rm i in sector k given byi

Pi @Pk
PiYi
=:
Pk Yk
Pk @Pi

The elasticity of demand, ~ i, coincides with that of monopolistic competition under two cases:{ When all rms are small, i.e. when their market share goes to zero,i ! 0:{ When = ; under this condition rms do not have leverage ina ecting sectoral prices. The empirically-relevant case is one inwhich > . Monopoly power rises with the market share.

Optimality conditions with exible prices
Domestic rms:

Ph;t =~ h;t~ h;tWt;
1 At

Foreign Firms:

Pf;t =~ f;t~ f;t

StWt
1 At

where ~ h;t and ~ f;t are no longer constant and instead depend on marketshares and therefore on prices.

In a log-linear approximation we get:P^h;t =P^f;t =sf

1+^ t + S^t(Wsh ^(Wt1+^t ) +A

1 + (11 + (1^At ) +1+sf )^t(W^t);Ash ) ^(Wt + S^t^t ):A1+

wherewith(111N)=N; sh = Nh=N and sf = Nf =N:

Implications:
Domestic and foreign prices in the home market are a weighted averageof domestic and foreign marginal costs.
Global-slack hypothesis: domestic prices depend on foreign marginalcosts. The more, the higher is the fraction of foreign rms in themarket (for given size N )Globalization should increase the pass-through. Pass-through of foreign costs or the exchange rate into import prices depends as well on
the degree of competition. Pass-through is increasing in the number
and share of foreign products in the domestic market. It is unitary
when one of the following condition is met: 1) = ; 2) N ! 1; 3)
sh = 0:In ation dynamic
Canonical New-Keynesian model implies the following AS equationh;t = k mct +Et h;t+1:

One issue of investigation has been the extent to which globalization
can change the slope of the curve (See Sbordone, 2007)

In an open economy, marginal costs are not just a function of thedomestic output gaph;t = k[yh;t(1n) (P^f;tP^h;t)] + Et h;t+1;

but also of the relative price. Foreign slack can be important. However,
it works counter-intuitively.

Our model instead implies variation in the mark-up due to changes in
the market share
1 ^=kmc+
th;th;t + Et h;t+1 ;Nand therefore in the relative prices
h;t = kh

mct + sf (P^f;tiP^h;t) + Et h;t+1:

Relative-price channel now goes in the right direction, a fall in foreign
prices puts downward pressure on domestic in ation for given marginalcosts. (see Gust et al., 2008, with Kymball's preferences)

The additional channel disappears{ when all rms become small in size (N goes to in nity implying
goes to zero), nesting the monopolistic-competitive market,{ or when the share of foreign rms is small (sf goes to zero),{ or in the particular case in whichto zero.

= ; implying also thatgoes

Steepening of the Phillips curve: an increase in Nf , rises N and, forgiven Nh; implies an increase in the slope of the Phillips curve. Hence,on the one side, globalization implies that prices become more sensitive
to variations in the marginal costs as increases.

Starting from a low share of foreign rms in the market, globalization
makes the AS equation more dependent on foreign conditions, the`foreign slack'.

In sectors with low degree of concentration, the relative-price channel
is less important and a further increase in the presence of foreign
products makes it smaller.

Eexchange-rate pass-through under sticky prices
Price stickiness and strategic pricing interact in explaining the dynamicof exchange-rate pass-through.
P^f;t = P^f;t 1+ Et

1X(j=0)j"(1) ^(Wt+j + S^t+j ) +#1 1^
f;t+j ;N

Even if foreign prices are perfectly exible, sticky domestic prices imply
imperfect short- and long-run pass-through (short lower than long)contrary to the implication of a standard monopolistic competition
model.

Dynamic of market share in uences the short and long-run pass-through.

The degree of pass-through is:{ decreasing with the degree of price stickiness of foreign rms;
{ is increasing with the share of foreign rms in the domestic market.

Globalization should increase the degree of pass-through for given degree of nominal rigidity and more when the degree of rigidity is lower.

Empirical Analysis on Pass-ThroughEmpirical analysis on the e ects of globalization on the exchange-ratepass-through using manufacturing data on US

5 manufacturing 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. Data are quarterly from 1993 to 2008.

Food

Leather

−4.5

−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

4.52
4.5

4−4.9

−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

4.45

−4.9

1994

1998

2002

2006

1994

1998

Transportation

−4.9

1994

1998

2002

2002

2006

Metal2006

1994

1998

2002

Exchange rate

2006
Import price

4.5

−4.6

4.7

−4.7

4.65

−4.8

4.6

−4.9

1994

19982002

2006

4.55

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 real exchange rate ( p= q ) computed on the intervals 1993-2000
and 2001-2008 for the ve sectors considered: 1) vegetables and preparedfood, 2) leather and footwear, 3) textiles and textile articles, 4) vehicles,
vessels and associated transport equipment, and 5) base metals and machinery.

Test the following linear modelsmXk;jqk;t j + "k;tpk;t = ck + k pk;t 1 +mXk;jpk;t = ck +(1)j=0qk;t j + "k;t;(2)

j=0y pk;t = ck +ky qk;t + "k;t(3)2y pk;t = ck +k

2y qk;t + "k;t(4)Model (A)Until 2001 Q1
After 2001 Q1

Sector 1
0.497
0.259
0.483

Sector 2
0.192
0.158
0.290

Sector 3
0.081
0.124
0.059

Sector 4
0.130
0.153
0.159

Sector 5
0.669
0.631
0.645

Model (B)
Until 2001 Q1
After 2001 Q1

0.540
0.1680.560

0.201
0.147
0.288

0.083
0.115
0.042

0.080
0.108
0.103

0.711
0.840
0.699

Model (C)Model (D)

0.409
0.554

0.154
0.164

0.076
0.095

0.086
0.087

0.439
0.630

Table 2: Estimated pass-through coe cients for Sector 1 (vegetables and preparedfood), Sector 2 (leather and footwear), Sector 3 (textiles and textile articles). Model(A) corresponds to equation ( 1), Model (B) corresponds to equation (2). Model (C)0 y st + "t where y represents the oneyear di erence operator. Model (D) corresponds to the following equation
2y pt =

to the following equationc + 0 2y st + "t where
signi cance level,y pt = c +2y represents the two-year di erence operator. Stars denote=1%, =5%, =10%.

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
00.04

00.35

00.02
−0.02

−0.05

−0.05
00.3

−0.1
2000

2004

2008

2000

2004

2008

2000

2004

−0.04
2008
2000

2004

2008

2000

2004

2008

Understanding the pass-through coe cientpk;t = ck +mX

k;jqk;t j + "k;t;j=0k;j=

0;k;j +

1;k;j HHt +2;k;j sharet :

(5)

ck
0;k;0
1;k;0
2;k;00;k1
1;k;1
2;k;1

Sector 1

Sector 2

Sector 3

Sector 4

Sector 5

0.006
3.155
-0.012-2.2963.387-0.01924.7870.002
5.182-0.029-0.472-5.305
0.029
0.884

0.001
-0.0860.00040.247
0.036
0.0004-0.3230.003-0.1480.0002
1.187-0.1860.00024.102-0.0024.560-0.0532.537
0.413-0.004
0.893

Table 4: Estimation of the non-linear model (5) 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 and machinery.

c1;k;02;k;03;k;0

Sector 1

Sector 2

Sector 3

Sector 4

Sector 5-0.033-4.567
0.020
14.95

0.012
3.294
-0.0190.302

0.008-0.1560.002-0.609

0.022
0.094
0.000
1.309

-0.0085.424-0.0572
2.317

Table 5: Estimation of the non-linear model (5) for the ve sectors considered where pk;t and qk;t are computed on a two-year horizon: 1)
vegetables and prepared food, 2) leather and footwear, 3) textiles and textile articles, 4) vehicles, vessels and associated transport equipment, and5) base metals and machinery.

Sector 1

Sector 2

Sector 3

Sector 4

Sector 5

1997

219.28167.2

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 theve sectors considered: 1) vegetables and prepared food, 2) leather andfootwear, 3) textiles and textile articles, 4) vehicles, vessels and associatedtransport equipment, and 5) base metals and machinery.

Empirical Analysis on the AS equation
Equation to be testedh;t = kh

mct + sf (P^f;twhich can be written as(P^h;tulct) =iP^h;t) + Et h;t+1;^ulct +1 (Ph;t 1 8ulct 1 )91<X=(Tt)(1( 1)[ ulcT + ! prT ] ;1 )Et :;T =twhere ! = sf and 1 is a function of k and.

Estimation strategy: nd k and ! which minimize deviations of (P^h;tulct) between data and model.

Manufacturing Sector
0.35

0.3

Non−Farm Business Sector
0.5Price
Unit labor cost
Relative Price

Price
Unit labor cost
Relative Price
0.4

0.25

0.2

0.3

0.15
0.2
0.1
0.1
0.05

00

−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

Manufacturing sector
(1)
(2)

k!

k!

k!

0:000Non-farm business sector(3)(4)

Full Sample 1993-2008
0:025
0:010

0:057

(0:024)(0:069)(0:048)(0:131)

00:32

00:04

0:001

(0:19)

Sample 1993-2000
0:001
0:024

(0:032)

0:019(0:0116)(0:0202)(0:0471)(0:0523)

0

0:25

0

0:05

0:002

(4:21)

Sample 2001-2008
0:1
0:02

(0:148)0:087(0:0275)(0:2429)(0:1098)(0:2969)

0

0:37

0

0:05

(0:1507)(0:0295)

Conclusion
Globalization, meaning a larger fraction of foreign products in destination markets, can have important e ects on the in ation dynamic of acountry and in particular on the degree of exchange-rate pass-throughand the slope/position of the AS equation.

We nd evidence that the pass-through has increased in the mostrecent years and that the relative-price channel is relevant in explaining
the domestic in ation dynamic.