Staff Discussion Paper/Document d'analyse du personnel 2016-20
The Paul Storer Memorial
Lecture-Cross-Border Trade
Integration and Monetary Policy
by Stephen S. Poloz
Bank of Canada Staff Discussion Paper 2016-20
September 2016
The Paul Storer Memorial Lecture-
Trade Integration
Cross-Border
and Monetary Policy
by
Stephen S. Poloz
Governor
Bank of Canada
Ottawa, Ontario, Canada K1A 0G9
spoloz@bankofcanada.ca
Acknowledgements
I am grateful for the support of my colleagues on Governing Council, and to a number of
others who helped with the research and commented on earlier drafts of this paper,
including Patrick Alexander, Karyne Charbonneau, Jean-Philippe Cayen, José Dorich,
Oleksiy Kryvtsov, Vadym Lepetyuk, Louis Morel, Daniel de Munnik and, especially,
Stephen Murchison. All remaining errors are mine.
Abstract
In this paper we explore the nexus between cross-border trade integration and monetary
policy. We first review the evidence that trade liberalization has increased the degree of
integration in North America and conclude that, while robust structural inferences remain
elusive, there is sufficient supporting evidence for central banks to treat the issue
seriously. The paper then discusses several channels by which increased integration
might affect macroeconomic models. We introduce modifications to the Bank of
Canada's main policy model, ToTEM, to capture some of the impacts of integration
suggested in the literature and generate stochastic simulations to compare versions of the
model with low and high integration. The main conclusion is that increased integration
may make it more challenging for central banks to control inflation, in the sense that
doing so will require more variability in interest rates, exchange rates and the output gap.
JEL classification: E37, E5, F1, F41, F6
Bank classification: Economic Models; Monetary Policy; Trade Integration
Résumé
l'intégration du commerce
Dans le présent document, nous étudions le lien entre
transfrontalier et la politique monétaire. Nous examinons d'abord les indications d'un
accroissement du degré d'intégration en Amérique du Nord induit par la libéralisation des
échanges et concluons que, si des inférences structurelles robustes restent difficiles à
cerner, la preuve recueillie est suffisante pour inciter les banques centrales à prendre la
question au sérieux. Puis, nous décrivons plusieurs canaux par lesquels l'intégration
accrue peut se répercuter sur les modèles macroéconomiques. Nous donnons un aperçu
des modifications apportées à TOTEM, le principal modèle macroéconomique de la
Banque du Canada, pour tenir compte de certains des effets de l'intégration mentionnés
dans la littérature, puis générons des stimulations stochastiques pour comparer des
versions du modèle comportant un degré d'intégration faible ou élevé. La conclusion
principale est que l'intégration accrue pourrait compliquer la tâche des banques centrales
lorsqu'il s'agit de maîtriser l'inflation, car une plus grande variabilité des taux d'intérêt,
des taux de change et de l'écart de production serait alors nécessaire.
Codes JEL : E37, E5, F1, F41, F6
Classification de la Banque : Modèles économiques, Politique monétaire, Intégration des
échanges
Introduction
Paul Storer was a special fellow. We met back in 1984 when he was fresh out of the
Master's program at the University of Toronto, and I was fortunate that he chose to
accept an appointment in my group at the Bank of Canada. I know I helped influence his
decision to go back to school three years later for his PhD, and his choice of the
University of Western Ontario, now known somewhat ironically as Western University.
While he was there, I was able to visit him from time to time, and it was a pleasure
watching him grow.
Sincere, dedicated, thoughtful, skeptical-these are some of the words I would readily
use to describe Paul. But most importantly, he was a very nice person, highly likeable
and a joy to work with. It never seems fair when we lose someone like Paul, but, to me,
this loss seems especially so, for we barely managed to stay in touch after he and his
wife Tina moved to Bellingham. Email from time to time, and a beer or dinner when he
and Tina were in Ottawa, it was always great to catch up, and now I treasure those
memories even more.
I'm very touched to have been invited to give today's lecture in Paul's memory, and I
wanted badly to do something that Paul would have appreciated. Fortunately, Paul had
wide-ranging research interests, so I had a lot to choose from. But he had clearly settled
onto Canada-US relations, particularly trade issues, as a core interest. And, his first
fulltime job was in monetary policy. So, today I have chosen to explore an issue he cared
about deeply-cross-border trade integration-and to do so through the lens of a
monetary policy practitioner.
Let me offer a quick sketch of my narrative. Paul had a strong interest in whether the
trade liberalization of the Canada-US Free Trade Agreement (CUSFTA), and the later
move to NAFTA, had actually led to increased integration of our two economies. His
work, often with Steven Globerman (see, for example, Globerman and Storer 2004),
finds little definitive evidence of increased integration of the Canada-US economies in
the wake of either CUSFTA or NAFTA. This seems to be the case whether you investigate
trade flows, investment flows, labour mobility, or the convergence in prices or factor
input prices.
At the same time, some of their findings suggest that the issue may be too complex and
the demands on the data too great to support rigorous empirical inference. In
particular, there are some large shifts in trade patterns at the sectoral level, suggestive
of increased specialization and more trade in components-in short, "supply chaining."
Moreover, as Globerman and Storer themselves observed, periodic significant
fluctuations in the Canada-US exchange rate, combined with a degree of domestic price
stickiness, are likely to pose challenges for empirical work around integration.
In what follows I will build on some of those observations and argue that there is more
(albeit soft) evidence of increased trade integration when the definition of trade is
broadened to embrace all the dimensions of international business. This includes
widespread supply chaining and the establishment of foreign affiliates selling directly to
host markets or third markets; in other words, globalization in its various forms. Indeed,
it is important not to restrict attention to the three NAFTA partner countries, since
additional countries (for example, China) may be important facilitators of integration
within North America. Statistical agencies are still catching up to these business trends,
so, by necessity, much of the evidence we will bring to the matter will be indirect. We
make no rigorous empirical claims, especially related to the effects of specific trade
agreements, but suggest that the evidence of increased integration is sufficient for
monetary policy to take it seriously.
This issue intersects with monetary policy along at least two dimensions. First, monetary
policy formulation depends heavily on empirical economic models, and the evolution of
international business is certain to have consequences for model structure and for key
model parameters. For example, domestic inflation may come to be driven more by
global demand and supply, and less by domestic forces. As well, the effects of
fluctuations in domestic interest rates and exchange rates on the domestic economy
may diminish as economies become more integrated.
The second dimension relates to monetary policy strategy, including both the
appropriate choice of target for the central bank to aim at and the time horizon over
which it should attempt to exert control. In attempting to smooth real economic
fluctuations-with the goal of achieving an inflation target-the central bank creates
interest rate and exchange rate fluctuations. These fluctuations may need to be greater
in a world where increased cross-border integration has weakened some of the key
macroeconomic linkages relied upon by central banks. These shifting trade-offs need to
be well understood in order to frame appropriate policy choices. We will explore these
policy issues using a state-of-the-art macro model of the Canadian economy.
Trade Evolution and Economic Integration
We begin by describing the various ways in which trade has evolved in North America
during the past 30 years. The concept of "trade penetration" is one useful proxy for the
importance of international trade for the domestic economy since it goes beyond the
traditional concept of exports. We use a country's nominal exports plus its imports as a
share of nominal GDP to measure the importance or "penetration" of trade into
domestic value creation, focusing on trade in goods for convenience. In a globalized
world, where production processes are often geographically fragmented, the
competitiveness of a country's exports depends increasingly on inputs imported from
other countries, since that facilitates the division of labour between lower-wage and
higher-wage workers. Clearly, this fragmentation boosts international trade for a given
level of GDP. In effect, we trade parts, and then we trade the final products, which
implicitly means trading the parts again (Hummels, Ishi and Kei-Mu 2001; Yi 2003; Chen,
Kondratowicz and Kei-Mu 2005).
Chart 1 offers some data on trade penetration of goods for the world and for the three
NAFTA economies. At the global level, trade penetration rose steadily from the early
1990s through to the collapse in trade after the global financial crisis in 2007-08. There
was a recovery in trade penetration after the ensuing global recession, but since 2010
total trade has been flat or even declining slightly in importance to global GDP.
The weakness of global trade growth in the past few years has attracted considerable
attention (Francis and Morel 2015; Poloz 2016). A key reason seems to be that
globalization has happened in waves that cannot be expected to be repeated. Early
development of global value chains (GVCs) was mainly the product of technological
improvements and falling tariffs and other costs, such as transportation and logistical
support costs. GVC development received a major boost when China joined the World
Trade Organization (WTO), which, again, can only happen once (Ferrantino and Taglioni
2014; Constantinescu, Matoo and Ruta 2015). A second reason is that the world has
entered a phase of subdued business investment because of the weight of post-crisis
uncertainty, and investment spending is a very trade-intensive activity. Accordingly, soft
investment has a disproportionate effect on global trade flows (Morel 2015). A third
reason, offered by Stratford (2015), is that emerging markets generally have lower
import elasticities than advanced economies; consequently, as the relative contribution
of emerging economies to global GDP growth rises, the global income elasticity of trade
has been declining. It is therefore reasonable to expect global trade to pick up as the
world economy gathers momentum; but it seems less likely to exceed global GDP
growth to the same extent as in the past.
This global pattern in trade penetration has been mimicked by the US economy. Canada
and Mexico have had different experiences, however. Mexico has seen a steady rise in
trade penetration for more than 30 years, with a big acceleration coming on the heels of
NAFTA in 1994. There was a minor decline in trade in the wake of the global financial
crisis, but the uptrend resumed right afterward. In contrast, Canada saw no rise in trade
penetration in the immediate aftermath of CUSFTA in 1988 (indeed, trade penetration
was in a downtrend) but then saw a rapid rise in trade penetration from 1991-2000.
NAFTA may have contributed to this rise after 1994, but the fact that much of the 1990s
increase in trade penetration was unwound during the following decade suggests that
other forces may have been at work. One contributing factor was the global telecom
boom and subsequent bust, in which certain Canadian companies were active
participants. Another was the steady appreciation of the Canadian dollar from 2002 to
2008, and its persistent strength in the aftermath of the global financial crisis. This
resilience was mainly the product of high oil prices, which led to considerable
restructuring in many export sectors, including automobiles and forestry products, and
the outright exit of large numbers of exporting companies. The US business cycle was
also a contributor. Since 2010, a modest uptrend in trade penetration has resumed in
Canada.
Chart 1: Evolution of the trade penetration of North American countries
Nominal merchandise imports and exports as a share of GDP, annual, 1980-2015
% %
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Advanced economies United
World Advanced Economies Canada U.S. Mexico
States
Sources: International Monetary Fund, Haver Analytics and Bank of Canada calculations Last observation: 2015
By this simple measure then, one would conclude that the three NAFTA countries have
become more integrated with the global economy during the past 30 years, especially
Mexico. The latter observation fits one's priors that smaller countries tend to have the
most to gain from trade liberalization. It is also consistent with empirical evidence in
Romalis (2007), showing that export volumes between these countries increased
significantly because of NAFTA. See also Caliendo and Parro (2015), who develop a
calibrated model suggesting that NAFTA augmented intra-North American trade by
118 per cent for Mexico, 41 per cent for the United States, and 11 per cent for Canada.
The implications of these trends for goods exports in the three NAFTA economies are
illustrated in Chart 2. Exports as a share of GDP have almost doubled in the United
States in the past 30 years but have been showing weakness recently. Mexico has seen a
steady rise in exporting, particularly in the wake of NAFTA, and today has an
export-toGDP ratio approaching 35 per cent. In contrast, the export sector trauma of the 2000s
has taken Canada's export-to-GDP ratio from a high of 37 per cent to about 26 per
cent-albeit resuming a modest uptrend-today.
Chart 2: North American exports as share of GDP
Nominal total merchandise exports as a share of GDP, annual, 1980-2015
%
%
40 40
35 35
30 30
25 25
20 20
15 15
10 10
5 5
0 0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
United
Canada US Mexico
States
Last observation: 2015
Sources: International Monetary Fund, Haver Analytics and Bank of Canada calculations
The concept of total trade penetration embodies the idea that countries trade not just
in final goods but in the components that go into them. Indeed, this is the essence of
the benefits of globalization. A given product can be fragmented into various
components, some of which require highly skilled, highly paid workers and some which
can be mass produced at low cost in lower-wage locations. Trade connects these
fragments together into GVCs and permits better matching between skills and products
and therefore lower overall costs and higher productivity. GVCs clearly boost
conventional trade statistics for a given unit of GDP and make interpretation of those
statistics more difficult.
One way to tackle this issue and gain insight into the degree of cross-border integration
is to examine the flow of intermediate goods between countries. After all, consumers
are not interested in intermediate goods, only the finished product. Trade in
intermediate goods is, therefore, business to business and productivity-enhancing.
Chart 3 shows the trends in global trade in intermediate goods for the NAFTA countries.
These data show that there has been a strong tendency for trade in intermediate goods
to grow in all three countries. While all three have seen an uptrend since NAFTA, the
large acceleration after 2000 suggests that the bigger influence may have been China's
accession to the WTO. The level of intermediate goods trade for the United States
dwarfs that for Canada and Mexico by factors of four and seven, respectively. The
importance of intermediate goods trade to the US economy is consistent with its role as
a global hub for multinational enterprises (MNEs) that develop GVCs spanning multiple
countries, including its NAFTA partners. Although it would be difficult to disentangle
these data, they are at least consistent with a rising degree of North American
integration over the past 20 years.
Chart 3: Global trade in intermediate goods by NAFTA countries
Total trade (imports and exports) of intermediate goods, annual, 1991-2014
US$ billions
US$ billions
800 800
700 700
600 600
500 500
400 400
300 300
200 200
100 100
0 0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
United
Canada U.S. Mexico
States
Last observation: 2014
Sources: World Integrated Trade Solution and Bank of Canada calculations
Trade in intermediate goods goes far beyond refined raw materials or minor parts to
include full subsystems. Trade in automobiles provides an illustration: a very large
portion of the total value added in an automobile comes from the parts and subsystems
made by manufacturers in the supply chain, whether they are building engines,
transmissions, electronic systems or even glass. Final assembly of vehicles is in fact a
relatively low value-added activity today-amounting to well under 10 per cent of the
final value of the automobile-with much more value added embedded in the parts and
subsystems made by suppliers. Aircraft manufacturing is broadly similar in this respect.
Supply-chain trade often happens within the same firm, the trade-facilitated version of
vertical integration. Thus, the MNE creates (or purchases) entities that supply it, thereby
increasing reliability, maximizing efficiency and perhaps internalizing the value added
(and profitability) that lies in the supply chain. Such arrangements are very clear in the
manufacturing sector of the NAFTA countries. For the United States, some 40 per cent
of manufactured exports to Canada are intra-firm, and about 50 per cent of imports
from Canada are also intra-firm. Similarly, around 40 per cent of US manufactured
exports to Mexico are intra-firm, but a much higher proportion of US imports from
Mexico-70 per cent-are intra-firm. These data point to a very high level of
crossborder integration, at least in certain manufacturing sectors, including automobiles,
aerospace and telecommunications equipment.
As noted earlier, trade through a value chain creates some double-counting, or perhaps
more appropriately multi-counting, of trade flows, because the same items cross
borders more than once. Consider a mobile phone, designed and engineered in one
country, assembled in another country from components produced in several other
supplier countries and then sold to the entire world. Even in this relatively simple
example, parts of the phone cross borders more than once, and each time that value is
recorded as someone's export. What this means is that any change in the structure of
global value chains can either inflate or depress normal "gross" trade flows.
In an effort to understand these phenomena better, the Organisation for Economic
Co-operation and Development (OECD) has developed indicators of "trade in
valueadded terms," which attempt to capture the value added in each country's participation
in a value chain. Viewed from the domestic lens, building a global value chain means
outsourcing content of the final product, thereby reducing its domestic content. The
OECD data show that 45 of 61 economies have seen a decline in the domestic content of
their exports over the past 20 years (Chart 4). This includes Mexico, where the
maquiladoras (suppliers clustered near the Mexico-US border) have captured
considerable offshoring activity from US and Canadian firms. Indeed, the maquiladoras
today account for over 25 per cent of manufacturing employment in Mexico (Bergin,
Feenstra and Hanson 2009), while at the same time incorporating imported inputs from
Asia and elsewhere in Latin America.
Chart 4: Domestic value added share of gross exports
%
%
100 100
1995
95 95
2011
90 90
85 85
80 80
75 75
70 70
65 65
60 60
Canada United States Mexico Euro area Japan China Average of 62
economies
Note: "62 economies" equals 61 countries plus OECD's "Rest Of World"
Source: Trade in Value Added (TiVA), Organisation for Economic Co-operation and Development
Chart 5: Domestic value added share of gross exports in the manufacturing sector
% %
100 100
1995
90 90
2011
80 80
70 70
60 60
50 50
Canada United States Mexico Euro area Japan China Average of 62
economies
Note: "62 economies" equals 61 countries plus OECD's "Rest Of World"
Source: Trade in Value Added (TiVA), Organisation for Economic Co-operation and Development
While these observations fit our hypothesis of increased integration across a large
number of economies, two exceptions are worth noting. One is Canada, where there
has been a modest increase in domestic value added to total exports. The reason for
this is that Canada's growth engine during much of the 2002-12 period was in the
commodity sector-primarily oil-and this is of course largely domestic value added.
Data from Canada's manufacturing sector clearly show a declining portion of domestic
value added, reflecting a globalization trend (Chart 5). The other interesting exception is
China, which has been by far the most important recipient of GVC business, often in
very labour-intensive forms. This means that the explosion of global trade in the wake of
China's accession to the WTO has contained a large share of Chinese domestic value
added. Over time, however, China has been creeping up the value-added chain,
particularly in manufacturing, as Chart 5 illustrates.
Yet another indicator of rising cross-border integration is the growing importance of
foreign affiliates in facilitating trade. A domestic company has a choice of producing at
home and shipping abroad, or locating abroad and shipping directly to that host country
and to third countries. Either arrangement may be supported by a global value chain.
Importantly, both CUSFTA and NAFTA liberalized and offered legal protection of
crossborder investment, so to understand the effects of these agreements we need to look
beyond the cross-border flows of goods and services.
Data on the operations of foreign affiliates with domestic majority ownership are less
widely available and reported with a substantial lag. That being said, by 2013, sales by
Canadian-owned foreign affiliates almost matched the amount of total exports sold
from Canada, at Can$510 billion versus Can$573 billion, respectively. In effect, there is
almost as large a Canadian economy operating in foreign countries as there is in the
domestic export sector, creating jobs and GDP both domestically and abroad.
Canadianowned affiliates operating in the United States account for about half of this total
activity and employ some 600,000 people in the United States; Canadian operations in
Mexico generate sales of about Can$15 billion and employ nearly 70,000 people in that
country. The number of associated jobs in Canada is much more difficult to estimate.
Importantly, the corresponding US figures are an order of magnitude greater. US
affiliates operating abroad generate annual sales of some US$6 trillion, with over
US$600 billion of that taking place in Canada, and over US$200 billion in Mexico. These
are very large numbers; at a minimum, they imply that standard export and import data
provide a very incomplete picture of the complexity of international business
relationships.
While these observations are not definitive, they collectively support the view that
cross-border integration has increased in North America over the past 20 years. As
mentioned above, deeper structural evidence of increased integration is harder to come
by, especially related to specific trade agreements. This is probably because the effects
of trade agreements are highly sector-specific, often even firm-specific, and there are
always numerous other forces that affect macro statistics. For example, some sectors
may have been more protected than others before a trade agreement, so outsized
adjustments may be masked in the aggregate data. Shifts in industry composition or in
factor intensity can easily distort micro phenomena when aggregated into macro
statistics. And, there may be subsequent shocks that hit particular industries.
Nevertheless, the literature has built a number of insights on the effects of specific trade
agreements over time. For example, in the wake of CUSFTA, Canada's manufacturing
sector saw a 5 per cent drop in employment and a 6 per cent increase in productivity.
Looking at a finer level of detail, those industries with the deepest tariff cuts saw a drop
in employment by some 12 per cent and a rise in productivity of around 15 per cent.
Importantly, these employment effects were erased over the longer term, as job gains
were made in other manufacturing companies (Trefler 2004; Lileeva 2008). In related
work, Lileeva and Trefler (2008) show that improved access to foreign markets induces
productivity-enhancing investment. McCalman and Spearot (2013, 2015) provide
evidence that US firms in the auto sector re-configured their GVCs in response to
NAFTA. Mexico was an important beneficiary. Many of these changes are most dramatic
at the firm level, which underscores the role of intra-industry reallocation in facilitating
structural adjustment to trade liberalization (Melitz 2003).
As for convergence in factor pricing, Caliendo and Parro (2015) find that NAFTA lowered
the terms of trade for Canada by 0.1 per cent and for Mexico by 0.4 per cent, while
raising the US terms of trade very slightly. Although real wages increased for all three
economies, Mexico showed the largest gains-weakly suggestive of some degree of
factor price convergence. The generally positive income effect of trade liberalization
highlighted in the basic model of trade (Krugman 1980) receives surprisingly little
attention. The main channel for this effect is falling import prices, and the positive effect
of lower import prices on domestic purchasing power can be easily lost in the debate
about how domestic producers will compete and how many domestic jobs may be lost.
Job losses may not be well captured by import price indexes when a central result of
trade liberalization is an increase in the number and variety of products that become
available to domestic consumers (Feenstra 1994; Kehoe and Ruhl 2013). Another
complicating factor in this research is the possibility that profit margins may not be
constant, which may weaken the pass through of decreases in costs that come from
trade liberalization to domestic consumers (De Loecker et al. 2012).
Summing up, a broad-brush review of data on international business and the empirical
literature demonstrates substantial evidence that that cross-border trade integration
has increased in the past 20 years. At the same time, it remains possible to be skeptical
of the depth of the integration hypothesis, especially attempts to credit either CUSFTA
or NAFTA specifically with the observed trends in the trade data, since definitive
structural empirical evidence to support it is limited. Certainly, the impact of the two
agreements on trade seems to have fallen short of predictions made by proponents
during pre-agreement debate.
Furthermore, some would point to recent evidence of integration reversals, as certain
industries have "reshored" back to the United States. However, it is important to keep
such anecdotes in perspective; globalization was never likely to take us to an idyllic
endstate of pure integration, since the realities of international commerce continue to
intrude. These realities include the limited availability of trade finance in many smaller
countries, the costs of building and maintaining global logistics networks, geopolitical
risks, the preference to have suppliers closer to buyers, and long-distance after-sales
service and maintenance, just to name a few.
Most importantly, perhaps, the trend to factor equalization-although not proven, it is
easy to see rising wages in China or Mexico, for example-creates a new optimization
problem for MNEs with GVCs whenever a company undertakes periodic strategic
reviews of its cross-border structure. Such reviews can lead (and have led) to decisions
to re-shore parts of the supply chain back to the home country-in short, the optimal
supply-chain arrangement can vary considerably over time as underlying conditions
evolve. This means that the degree of integration may also vary significantly over time,
in both directions, making it risky to treat it as a permanent state of the world.
My overall reading is that the evidence of increased international integration is
sufficiently compelling for policy-makers to take it seriously, since it may affect their
policy models and decision-making frameworks. These issues are explored in the next
section.
Integration and the Monetary Policy Transmission Mechanism
It is easiest to think about the implications of these trends in international trade in the
context of a textbook open-economy model with inflation driven by a Phillips curve and
the central bank targeting inflation. In this framework, a macroeconomic shock moves
projected inflation off target and the central bank adjusts interest rates in a manner that
brings inflation back to target over the next six-to-eight quarters. For ease of exposition,
assume a negative shock to foreign demand, prompting the central bank to cut interest
rates to keep inflation on target.
The interest rate response of the central bank works mainly through intertemporal
substitution by both consumers and firms, who borrow more and spend more on goods,
housing and investments. Meanwhile, the cut in interest rates is associated with some
depreciation in the domestic currency, which boosts exports and dampens imports,
broadening the policy effect on aggregate demand. The weaker currency may also have
partially offsetting effects on consumer spending and investment spending because of
the higher cost of imports. The depreciation of the exchange rate boosts domestic
inflation temporarily. However, the increase in domestic aggregate demand combined
with these other effects offsets the drop in foreign demand and brings inflation
sustainably back to target.
The monetary policy transmission mechanism relies in the first instance on two key
reduced-form parameters: the interest elasticity of aggregate demand and the exchange
rate elasticity of aggregate demand. The issue to consider is how the evolution of
international trade may have influenced these parameters over time, either directly, or
through more subtle changes in the underlying structure of the economy. The ultimate
effects on inflation will depend on the interaction between the domestic output gap and
domestic inflation (the Phillips curve). Each of these relationships may be altered by an
increase in cross-border integration.
To illustrate, let's compare a world in which entire products are produced in individual
countries and exported to others, with one that is "integrated" or "globalized,"
dominated by MNEs with suppliers scattered around the world. In both states, global
demand for a given product is the ultimate demand shock variable. However, the
investment decisions of an MNE will be driven more by global variables than individual
domestic variables. This could include interest rate fluctuations-assuming the MNE has
access to global capital markets, its decision making may be less influenced by domestic
interest rates and more by global interest rates. To date, however, there is very little
empirical evidence for or against this conjecture, so we have set it aside.
Similarly, a fluctuation in an individual exchange rate may have a more muted impact on
MNEs in a globalized world, because for any given MNE built on GVCs, the depreciation
of one currency means an appreciation of another, both of which could be in the firm's
portfolio of demand and supply. In concrete terms, as a country becomes more
integrated into GVCs, a depreciation of the exchange rate improves its competitiveness
by only a fraction of the value of final goods exports, rather than the whole bundle
(Ahmed, Appendino and Ruta 2015). Furthermore, notice that the proces