metadata: authors: 0: author: De Soyres,Francois Michel Marie Raphael
1: author: Franco Bedoya,Sebastian
count: World
docna: 0: docna: Inflation Dynamics and Global Value Chains
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,Industrial and Consumer Services and Products,Transport and Trade Logistics,Inflation,Macroeconomic Management
teratopic: International Economics and Trade,Industry,Transport,Macroeconomics and Economic Growth
abstracts: cdata!: The global economy has witnessed a
            decline in inflation and an increase in inflation
            synchronization since the early 1980s. This paper
            investigates the relationship between inflation
            synchronization and trade integration, and documents the
            strong link between inflation co-movement and Global Value
            Chain (GVC) participation. Using 35 years and both gross and
            value-added trade flows, evidence shows that an increase in
            production linkages, as proxied by trade in intermediate
            inputs, is strongly associated with higher inflation
            correlation. Moreover, backward GVC participation is
            associated with an increase in bilateral inflation
            co-movement while forward participation is linked with a
            higher correlation between domestic and worldwide inflation.
            The paper also finds evidence of the effect of trade
            integration in decreasing inflation levels.
repnme: repnme: Inflation Dynamics and Global Value Chains
display_title: Inflation Dynamics and Global Value Chains
listing_relative_url: /research/2019/12/31651362/inflation-dynamics-global-value-chains
topicv3: Industrial Clusters and Value Chains
            m1326062 1226,Global Value Chains(GVC) m1326472 767,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Monetary Policy m1327609 444
publishtoextweb_dt: 2019-12-18T00:00:00Z
historic_topic: International Economics and Trade,Industry,Transport,Macroeconomics and Economic Growth
origu: World Development Report (DECWD)
no_of_pages: 29
author_keys: 0: author_key: 1594973
1: author_key: 1559848
model_extractions: Policy Research Working Paper 9090 World Development Report 2020 _Background Paper_ Inflation Dynamics and Global Value Chains _François de Soyres Sebastian Franco_ Development Economics World Development Report 2020 Team December 2019
Policy Research Working Paper 9090

# **Abstract**

The global economy has witnessed a decline in inflation and an increase in inflation synchronization since the early 1980s. This paper investigates the relationship between inflation synchronization and trade integration, and documents the strong link between inflation co-movement and Global Value Chain (GVC) participation. Using 35 years and both gross and value-added trade flows, evidence shows that an increase in production linkages, as proxied by trade in intermediate inputs, is strongly associated with higher inflation correlation. Moreover, backward GVC participation is associated with an increase in bilateral inflation co-movement while forward participation is linked with a higher correlation between domestic and worldwide inflation. The paper also finds evidence of the effect of trade integration in decreasing inflation levels.

This paper is a product of the World Bank’s _World Development Report 2020_ Team, Development Economics. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/ prwp. The authors may be contacted at francois.m.desoyres@frb.gov.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Inflation Dynamics and Global Value Chains

François de Soyres & Sebastian Franco World Bank<sup>_∗_</sup> Keywords: inflation synchronization, global value chains. JEL classification: E16, E31, F1, F14, F15, F42, F62.

> _∗_ This is a background paper for the World Bank’s World Development Report 2020 "Global Value Chains: Trading for Development". We thank the WDR 2020 team for their comments. The views expressed in this paper are solely those of the authors and do not necessarily reflect those of the World Bank.
# **1 Introduction**

To what extent does domestic inflation react to changes in foreign economic conditions? Is the widely debated “globalization of inflation” related to the rise in the interconnection of production structures across countries? The starting point for this paper is the simple observation that the global economy has witnessed a decline in inflation and an increase in inflation synchronization across countries since the early 1980s. Figure 1 plots the evolution of World inflation since 1980. Although the curves are not monotonous, the downward trend in World inflation is very clear. As many countries entered a phase of “great moderation”, fluctuations in price levels seemed to be dampened.<sup>1</sup> Dis-aggregating this observation by income groups, one can see that the phenomenon is more pronounced for high income countries, while middle- and lowincome countries have been more volatile but also display a downward trend in inflation.

Beyond characterizing the reduction in the _level_ of inflation, this paper focuses on the recent evolution of the _co-movement_ of inflation between countries. For this purpose we compute the correlation of inflation measures using a rolling time windows from 1980 to 2015. Figure 2 plots the evolution of inflation synchronization, measured as the averaged correlation of domestic inflation and world inflation. While inflation in the 1980s seemed to be mostly associated by domestic factors and did not exhibits strong correlation across country, the picture is very different for more recent time windows. Interestingly, the increase in inflation co-movement happened both for Consumer Price Index (CPI) and for the GDP deflator, implying that both firms and consumers experienced more synchronized price fluctuations over the past few decades.

This paper investigates the relationship between inflation synchronization and trade integration, and in particular documents a strong association between several indices of Global Value Chain (GVC) participation and the co-movement of inflation. As a first step, we use gross trade flow which we separate between trade in final good and trade in goods that are used in production (which include intermediate inputs and capital goods). Controlling for country-pair fixed effects, as well as common exposition to third countries, we show that an increase in trade in goods that are used in production is significantly associated with an increase in the correlation of GDP-deflator inflation.

> 1The Great Moderation usually refers to the reduction in the volatility of business cycle fluctuations in developed nations starting in the mid-1980s, compared with the decades before.

2
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dependence is reminiscent of the literature on trade and business cycle co-movement: since Frankel and Rose (1998) and Kose and Yi (2001), many papers have documented the link between international trade and GDP co-movement at business cycle frequency. More recently de Soyres and Gaillard (2019) emphasized the specific role of trade in intermediate input in the rise of business cycle synchronization across countries. In this sense, GVC participation will be associated with a rising synchronization of real economic activity and inflation across countries.

The reminder of the paper is organized as follows. Section 2 presents a brief literature review. Section 3 documents the data sources. Section 4 presents our empirical strategy. Section 5 presents our main results and section 6 concludes.

# **2 Literature review**

The “Globalization of Inflation” is a phenomenon that has been discussed heavily in the literature over the past few years. The decline in the level and persistence of inflation after 1980 is seen as a common feature of the most industrialized economies in the world (Mumtaz and Surico, 2012). Ciccarelli and Mojon (2010) use data for 22 OECD countries and conclude that a common factor accounts for 70% of the variability of country inflation, on average. Changes in the conduct of monetary policy across the world have contributed on this regard (Rogoff, 2003). Interestingly, trade models also provide guidance on this regard. For instance, Melitz and Ottaviano (2008) develop a theory in which openness decreases average mark-ups and lowers inflation across economies experiencing an increase in integration through trade. In this section, rather than providing a complete review of the studies explaining the global synchronization of inflation, we cover the recent literature studying the link between the global inflation synchronization and trade integration.<sup>2</sup> While most of this empirical evidence is based on the use data for advanced economies, it allows us not only to keep the discussion limited to the scope of the paper, but also to contextualize our results based on a broader set of both develop and developing countries.

GVCs expansion and the consequent change in the nature of trade can help to

> 2For a literature review of the range of factors that could be responsible for the global synchronization of inflation see for instance Ha et al. (2019).

5
explain the global inflation synchronization. Trade linkages increase the exposure of domestic inflation to foreign shocks and may lower import prices. Auer et al. (2017a) find that the expansion of GVCs has not only been an important contributor to the change in inflation dynamics, and it has become a key channel through which global economic slack influences domestic inflation, by making domestic inflation more sensitive to the global output gap.

There is strong evidence of the existence of international inflation spillovers that generates inflation synchronization through trade linkages. Auer and Mehrotra (2014), in the analysis most closely related to ours, find that both headline inflation rates and producer prices move more closely together between Asian-Pacific region economies that trade more with one another.<sup>3</sup> They show that in closely integrated supply chains, any shock to domestic production costs or exchange rates could be easily passed through to economies in the supply chain, affecting intermediate prices in other economies. More recently, Auer et al. (2017b) show that input-output linkages account for half of the global component of producer price inflation and that this synchronization across countries is driven primarily by common sectoral shocks and input-output linkages amplify the co-movement by propagating those shocks. Andrews et al. (2018) use data for 22 OECD countries over the period 1995 to 2014 to provide evidence that rising participation in GVCs has placed downward pressure on producer price inflation, by increasing the ability of firms to substitute domestic inputs with cheaper foreign equivalents. The mechanism at work is a downward pressures on unit labour costs (raising productivity and reducing wages) in the importing country.

Regarding the the policy relevance of inflation synchronization across countries, monetary policy is the most concerned. As supply chains represent a direct link between foreign marginal costs and domestic production costs, their prevalence has a significant effect on the extent to which optimal monetary policy is inward-looking (Auer et al., 2017b). In other words, this rise the question of to what extent central banks control domestic inflation dynamics (Carney, 2017). For this reason Central banks of the mayor advanced economies now pay attention to global developments when setting domestic monetary policy (Bernanke, 2007; Draghi, 2015; Carney, 2015).

> 3In Auer and Mehrotra (2014) the Asia-Pacific region includes Australia, China, Chinese Taipei, India, Indonesia, Japan and Korea.

6
Moreover, the same way that GVCs generate spillover effects and amplify those effects, global inflation synchronization might require more coordinated international policies (IMF, 2018).

Finally, beyond inflation synchronization, GVCs also create strong interdependence of GDP fluctuation at business cycle frequency (de Soyres and Gaillard (2019), Gunnella et al. (2019)). Moreover, the segmentation of production across countries has a significant impact on trade elasticities (Amiti et al. (2014), de Soyres et al. (2018)). GVCs also impact the extent to which regional trade agreement divert trade flows with the rest of the world (de Soyres et al. (2019)).

# **3 Data Sources**

The analysis is based on annual inflation data for more than 126 countries depending on the specifications, for the period 1970-2017.

## **3.1**

Inflation is measured at the annual frequency and the analysis are performed using two different measures: Consumer Price Index (CPI) and Gross Domestic Product Deflator (GDPD). There are key differences between those two indices. On the one hand, CPI includes all goods bought by consumers including foreign goods if the country imports final goods. As such, it is an interesting measure of price changes when one wants to focus the analysis on consumers only. On the other hand, GDP deflator measures price changes in goods and services produced in an economy, but not those imported. Moreover, the two measures have different shares of tradable goods, being higher for the CPI. Importantly, since there are production linkages between importers and non importers within each country, GDP deflator has an _indirect_ exposure to imported inputs. However, GDP deflator has no exposure to imported final goods that are simply consumed by households.

When building the data set on which we perform our analysis, we are particularly interested in covering as many countries and as many low income countries as possible. The use of CPI and GDPD allows to have two ( _very_ ) different measures, and guarantees 7
a wide coverage of countries over a log period of time. This data comes from the World Bank’s World Development Indicators (WDI).

# **3.2 Data on Trade Flows**

We collect data on bilateral trade flows from the Observatory of Economic Complexity (MIT). This database covers 215 countries over the period 1962-2014. The data are classified according the 4-digit Standard International Trade Classification (SITC), Revision 2. Only products and commodities are considered. Then, we aggregate these bilateral trade flows at the country-level.

To classify trade flows into final and intermediate goods, we use a concordance table from SITC Rev. 2 to Broad Economic Categories (BEC).<sup>4</sup> We then classify goods into five categories: primary, semi-finished goods, parts and components, capital goods, consumption goods, and a residual category called goods non-specified. We group these categories into intermediate and final goods as follows: intermediate goods are primary goods, semi-finished goods, parts and components; and final goods are consumption goods and capital goods.

# **3.3 Measures of GVC participation based on Value Added**

One of the main purposes in this paper is to identify production linkages between countries. Recent advances in data collection and theoretical decomposition of trade flows have shown the various ways of measuring GVC participation.<sup>5</sup> In this paper, we use the recent GVC indicators from Borin and Mancini (2019). They offer a new toolkit for value-added accounting of trade flows at the aggregate, bilateral, and sectoral levels that can be used to investigate a broad set of empirical questions—including in this case an assessment of the global inflation synchronization.

Based on this gross and value-added decomposition, we analyze the association between inflation co-movement and several indices of GVC participation and trade which are as described below.

> 4The concordance table from SITC Rev2 to BEC can be found on the UN Trade Statistics webpage: https://unstats.un.org/unsd/trade/classifications/correspondence-tables.asp .

> 5In particular, see Bems et al. (2011) and Johnson (2018)

8
First, we use a decomposition of exports based on gross flows:

- **_dagexp_fin_** is the part of share of gross exports that are final goods and hence are directly absorbed by the importer. It contains both domestic and foreign value added.

- **_dagexp_int_** is the part of share of gross exports that are intermediate inputs but are also directly absorbed by the importer, which means those are elements which are used in the destination production process and ultimately absorbed by consumer in the importing countries (i.e. not re-exported further). It contains both domestic and foreign value added.

- **_GEREF = Gross Exports - dagexp_int - dagexp_fin_** . This is the share of gross exports that are re-exported further. It contains both domestic and foreign value added.

Second, we define an alternative decomposition based on value-added flows:

- **_DVA_** is the _total_ amount of domestic value added embedded in gross exports.

- **_davax_fin_** is the domestic value added embedded in gross trade flows and exported as final goods. By definition, this component of the gross trade flows is directly absorbed by the importer.

- **_davax_int_** is the domestic value added embedded in gross trade flows, exported as intermediate inputs and absorbed by the importer (i.e. it accounts for the part that is either directly absorbed as well as the part which is re-exported further by the direct partner but is still ultimately re-imported back in the destination country for absorption).

- **_DVARF = DVA - davax_int - davax_fin_** . It corresponds to the share of domestic value added in exports that is not absorbed by the direct importer. Note that this part of the DVA can be absorbed in any third country in the world, or back in the origin country. This is sometimes referred to as the forward index of GVC participation.

Finally, we define GVC participation indices as follows: 9
||_Num_|_ber of cou_|_ntry-pairs with non miss_|_ing data_|
|---|---|---|---|---|
|**Year**|**GDP defator**|**CPI**|**Gross Trade data**|**Value Added data**|
|1970|139|103|215|-|
|1980|171|126|215|-|
|1990|206|166|215|189|
|2000|239|205|215|189|
|2010|248|230|215|189|
|2015|247|227|215|189|

- **_gvcb = Foreign Value Added + Foreign Double Counting Terms_** . This is the foreign content of exports and is sometimes referred to as the backward index of GVC participation.

- **_gvce = gvcb + DVARF_**

- This first index of GVC participation accounts for both backward and forward GVC participation and is the sun of foreign content in export as well as the domestic content of export that are re-exported further.

- **_gvc_broad_** = gross exports - _davax_fin_ .

- This second index of GVC participation is broader than the previous one as it also includes **_davax_int_** . This index measures all exports that are either intermediate inputs or foreign content. It only excludes from gross trade flows the share of domestic value added that is exported as final good and directly consumed by the destination consumers.

# **4 Methodology/Empirical Strategy**

While for the descriptive statistics in the first section the degree of global inflation synchronization was measured by the correlation of each country inflation and the World inflation, here we focus on the bilateral linkages and compute the correlation of country-pair inflation series.

10-year windows are used as benchmark due to the need to use no overlapping windows in the regressions. The use of 10, 15 and 20-year shows similar patterns in the evolution of the inflation correlations. The use of 10 and 15-year windows allows both to capture long-term and short-run fluctuation in the evolution of inflation correlation.

10
20-year windows eliminate the short-tun fluctuations that can provide important insights.

Throughout the rest of the paper, we denote by _π_<sup>_GDPD_</sup> and _π_<sup>_CPI_</sup> the inflation measures based on the GDP deflator and Consumer Price Index respectively. Overall, our analysis investigates the relationship between synchronization of those two inflation measures and GVC participation, and we use a variety of measures to capture the different aspects of GVC participation. The estimated equation is as follows: where _Corr_ ( _πi, πj_ ) _t_ is the correlation of the inflation measure between country _i_ and _j_ . _Tijt_ denotes a trade intensity index associated with an specific measure of GVC participation, _t_ . It is necessary to construct a symmetric measure of of the variable of interest, _t_ , relative to total GDP as follows: where _tj→j_ is the variable of interest from country _j_ to country _i_ , and _Tijt_ is the symmetric measure related to that variable. We include country pair, _FEij_ , and timewindow, _FEt_ , fixed effects in all the regressions to control for country-pair heterogeneity and global factors affecting the correlation of inflation respectively.

It is important to recognize that two countries _i_ and _j_ can be exposed to a common third country _k_ through trade linkages which would influence inflation in both _i_ and _j_ over and beyond the direct trade linkages. Indeed, even controlling for country-pair fixed effects cannot completely alleviate such a concern regarding the presence of a “global factor”, since the common exposure to a third market could be time varying and be more present in some time windows that others. To account for such a “third country” effect, we define the following _third country_ indicators, separating the common exposure due to similarity in import sources from the exposure due to similarity in 11
export destinations:<sup>6</sup> Those indices always lie between 0 and 1, and are equal to 0 whenever there is exactly no overlap between countries _i_ and _j_ import sources / export destinations. Indices are equal to 1 in the case where countries _i_ and _j_ have _exactly_ the same geographical exposure to import / export markets. They also capture unobserved characteristics regarding the trade frictions and trade policies.

It is also interesting to explore the link between the level of inflation and GVC participation. In other words, whether the expansion of GVCs has contributed the synchronized reduction in global inflation observed in figure 1. For this purpose, the estimated equation is the following: Note that equation 4 is country-centric, with the dependent variable being the level of inflation in country _i_ , _πit_ . Accordingly, the the trade intensity indices included in the regression, _Tit_ , are country specific and in relative terms to GDP, as follows: Finally, note that fixed effects included in equation , _FEi_ and _FEt_ , control for the country and time dimensions. And it is not necessary to account for third country

> 6We actually use the indices computed in de Soyres and Gaillard (2019), where they are utilized in an analysis of GDP rather than inflation synchronization.

12
# **5 Results**

This section presents the results, both from a country-pair and country-centric perspective. Our goal is to analyze the link between GVC participation and both the level (for each country) and the synchronization (for each country-pair) of inflation.

## **GVC and the synchronization of inflation across country-pairs**

In table 1, we use within country-pair variations and control for country-pair fixed effects as well as third country exposure to investigate the link between trade in intermediate inputs and the correlation of inflation for each pair of country. Results in column (1) show that the correlation of GDP deflator (GDPD) inflation increases when total trade proximity increases. This result is indicative that the determinants of GDPD inflation might not be domestic only, and that higher trade integration is associated with a link in the formation on prices. Moreover, we can dis-aggregate this results and separate total trade into trade in final goods and trade in intermediate inputs. Doing so, column (2) unveils an interesting insight about the specific role of Global Value Chains. While an increase in final good trade is _not_ associated with any significant change in inflation co-movement, the effect we observed through total trade is actually solely driven by trade in intermediate inputs.

This result is not very surprising since GDP deflator is defined net of imports. While imported final goods for consumption are simply not taken into account in the construction of GDP deflators, the effect of imported input can still have an impact through the effect of cost shocks on the prices of other firms down the production chain. Overall, our results show that GVC integration as proxied by trade in intermediate inputs creates a link between inflation fluctuation between countries and confirms the view that in a world with production sharing across countries, the determinants of inflation are not purely domestic anymore.

Following results presented in table 1, in table 2 we extend the analysis by using value-added data for trade flows instead of gross trade flows. Doing so is important because, for example, gross import flows might contain value added produce in a third country, in which case domestic inflation would be more likely to be synchronized not with the _direct_ import partner but with the country of origin of value added. Looking at column (1), we first find that the finding related to total trade is _reversed_ : while an 13
Table 1: Country-pair correlation regressions

||(1)<br>GDPD|(2)<br>GDPD|
|---|---|---|
|log total|0.010<sup>_∗_</sup><br>(0.006)||
|log int-cap||0.012<sup>_∗∗_</sup><br>(0.006)|
|log fn||-0.004<br>(0.005)|
|third ex|0.004|0.009|
||(0.059)|(0.059)|
|third im|-0.289<sup>_∗∗∗_</sup>|-0.290<sup>_∗∗∗_</sup>|
||(0.071)|(0.071)|
|N|15564|15564|
|R2|0.400|0.400|
|Time windows|5|5|
|Country pairs|6202|6202|
|Time FE|YES|YES|
|CP FE|YES|YES|

Standard errors clustered by country-pair in parentheses Note: observations with non-overlapping 10-year windows. _∗ p < ._ 1, _∗∗ p < ._ 05, _∗∗∗ p < ._ 01 increase in trade proximity using gross trade flows is associated with an increase in the synchronization of inflation, we now find a negative association between value-added trade and inflation correlation. Column (2), however, delivers new and interesting insight which allows us to better understand the negative coefficient in column (1): inflation correlation is actually _increasing_ with the value added exported as intermediate and absorbed by the direct partner, but it is _decreasing_ with value-added trade in final goods as well as with the value-added trade in intermediate that are re-exported further. Again, when two countries trade intermediate inputs that are absorbed by one another, then such a production link is indeed associated with higher co-movement of Findings in table 2 confirm the insights from table 1, and both analysis feature a 14
Table 2: Country-pair correlation regressions

||(1)<br>GDPD|(2)<br>GDPD|
|---|---|---|
|log index davax tot|-0.126<sup>_∗∗∗_</sup><br>(0.016)||
|log index davax fn||-0.048<sup>_∗∗_</sup><br>(0.022)|
|log index davax int||0.061<sup>_∗∗∗_</sup><br>(0.025)|
|log index DVARF||-0.137<sup>_∗∗∗_</sup><br>(0.021)|
|N|25692|25403|
|R2|0.575|0.575|
|Time windows|2|2|
|Country pairs|14823|14648|
|Time FE|YES|YES|
|CP FE|YES|YES|

Standard errors clustered by country-pair in parentheses Note: observations with non-overlapping 10-year windows. _∗ p < ._ 1, _∗∗ p < ._ 05, _∗∗∗ p < ._ 01 positive and significant association between bilateral inflation correlation and crosscountry production, as proxied either by total gross trade in intermediate inputs, or by value-added trade in intermediate inputs that are ultimately absorbed by the trade partner. The negative association between re-exported import and domestic inflation reveals that inflation dynamics and the association between two countries’ inflation does not only depend on how much they trade, but also on who is the ultimate consumer for those trade flows. Table 3 shows that the same results hold for the correlation of CPI inflation.

Table 4 comes back to the use of gross trade indicators but this time constructed using data from Borin and Mancini (2019) based on EORA data. The goal of separating the (gross) export flows that are directly absorbed from the share that is re-exported further. Results in column (1) show that the correlation of CPI inflation increases when two countries trade more intermediate inputs, which confirms the insight from 15
Table 3: Country-pair correlation regressions (APPENDIX)

||(1)<br>CPI|(2)<br>CPI|(3)<br>CPI|
|---|---|---|---|
|log index davax tot|0.017<br>(0.022)|||
|log index davax fn||-0.105<sup>_∗∗∗_</sup><br>(0.030)|-0.052<sup>_∗_</sup><br>(0.029)|
|log index vax int||0.128<sup>_∗∗∗_</sup><br>(0.034)||
|log index davax int|||0.110<sup>_∗∗_</sup><br>(0.037)|
|log index DVARF|||-0.057<sup>_∗_</sup><br>(0.030)|
|N|18220|18214|17989|
|R2|0.630|0.630|0.629|
|Time windows|2|2|2|
|Country pairs|11435|11432|11275|
|Time FE|YES|YES|YES|
|CP FE|YES|YES|YES|

Standard errors clustered by country-pair in parentheses Note: observations with non-overlapping 10-year windows. _∗ p < ._ 1, _∗∗ p < ._ 05, _∗∗∗ p < ._ 01 the analysis above albeit with different data. Interestingly, when disentangling gross trade flows of intermediates into the part that is ultimately absorbed by the importer and the part that is re-exported further, the analysis show that this positive link is exclusively due to the directly absorbed part. This result confirms the finding from table 3 and means that when looking at both gross and value added trade flows, the synchronization of inflation between two countries is mostly related to the trade flows – that are absorbed rather than re-exported further which could be indicative of more rigidity in the production chains designed for primarily serve domestic consumption rather than foreign consumers. In table 7 in appendix, we provide the results for the same analysis using CPI inflation as dependent variable instead of GDP deflator. Results are virtually unchanged.

16
Table 4: Country-pair correlation regressions

||(1)<br>CPI|(2)<br>CPI|
|---|---|---|
|log index dagexp fn|-0.141<sup>_∗∗∗_</sup><br>(0.050)|-0.070<br>(0.050)|
|log index exp int|0.140<sup>_∗∗∗_</sup><br>(0.052)||
|log index dagexp int||0.129<sup>_∗_</sup><br>(0.069)|
|log index GEREF||-0.076<br>(0.052)|
|third ex|-0.187|-0.177|
||(0.123)|(0.123)|
|third im|-0.407<sup>_∗∗∗_</sup>|-0.409<sup>_∗∗∗_</sup>|
||(0.151)|(0.151)|
|N|7992|7992|
|R2|0.607|0.606|
|Time windows|2|2|
|Country pairs|4767|4767|
|Time FE|YES|YES|
|CP FE|YES|YES|

Standard errors clustered by country-pair in parentheses Note: observations with non-overlapping 10-year windows. _∗ p < ._ 1, _∗∗ p < ._ 05, _∗∗∗ p < ._ 01

# **GVC and the level of**

Now we turn to the country-centric regressions to explore the link between GVC participation and the _level_ of inflation. In this case the GVC indices are created by aggregating the trade flows from the exporter perspective. That is to say, the link between each country and the rest of the World is what that country exports to all its trade partners. Such an analysis has been developed in Andrews et al. (2018). The basic argument is that integration into GVCs might contribute to lower inflation via downward pressures on labor costs by raising productivity and reducing wages in the importing country, especially when low-wage countries are integrated in supply chains.

17
Moreover, it might also lower producer price inflation by increasing firms’ abilities to substitute domestic for foreign inputs.

Table 5 studies this link using gross trade data in column (1) and value added trade data in column (2). Results show that, controlling for each country’s average level of inflation as well as global changes in inflation for each time window, an increase in trade in both final goods and intermediate goods re-exported further (forward linkages) is indeed associated with a downward pressure on the level of the GDP deflator inflation. This is in line with global inflation trend observed in figure 1. Column (2) confirms these results when using trade in value-added terms. Turning to columns (3) and (4), we use more “standard” GVC participation indicators to analyze the link between GVC and inflation level. The negative coefficients of these indices suggest that greater GVC integration contributed to the decrease in inflation levels. Again, those results also hold when using CPI inflation as the dependent variable, as shown in table 8 in appendix.

# **Graphical representation of some results**

In an effort to make our results more accessible for a wide audience, we present our main insights in figures 4 and 5.

First, focusing on backward GVC participation, figure 4 shows the strong association between an increase in bilateral inflation correlation using the GDP delfator and bilateral backward participation. In this graph, each dot is a pair of World Bank Region, with the vertical axis representing the change in inflation correlation between domestic CPI inflation and World inflation between 2001 and 2011, while the horizontal axis represents the change in backward GVC participation for the same period. This representation, in changes, allows to control for country fixed effects in an intuitive way since the only variation that is used is the _within region pair_ change in both inflation correlation and GVC participation.

Second, figure 5 shows that stronger backward GVC participation (in the horizontal axis) is associated with an increase in CPI inflation correlation (in vertical axis) between each country and the World. Inflation correlation, here, means the correlation between domestic inflation and world inflation, and the positive slope implies that an increase in 18
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Table 5: Country-centric regression in levels

|||(1)<br>GDPD|(2)<br>GDPD|(3)<br>GDPD|(4)<br>GDPD|
|---|---|---|---|---|---|
|log|index dagexp fnx|-1.823<sup>_∗∗_</sup><br>(0.819)||||
|log|index dagexp intx|3.477<sup>_∗∗_</sup><br>(1.432)||||
|log|index exp rexpx|-2.463<sup>_∗_</sup><br>(1.292)||||
|log|index davax fnx||-1.788<sup>_∗∗_</sup><br>(0.797)|||
|log|index davax intx||3.168<sup>_∗∗_</sup><br>(1.431)|||
|log|index vax rexpx||-2.410<sup>_∗_</sup><br>(1.281)|||
|log|index gvce broadx|||-0.877<sup>_∗_</sup><br>(0.502)||
|log|index gvcx||||-1.191<sup>_∗∗_</sup><br>(0.511)|
|N||833|830|833|833|
|R2||0.281|0.281|0.271|0.274|
|Ti|me windows|5|5|5|5|
|Co|untries|177|177|177|177|
|Ti|me FE|YES|YES|YES|YES|
|Co|untry FE|YES|YES|YES|YES|

Standard errors in parentheses Note: observations with non-overlapping 5-year windows. The GVC indices used in this table are computed from the exporter side. _∗ p < ._ 1, _∗∗ p < ._ 05, _∗∗∗ p < ._ 01 21