This increase in competition has put pressure on prices, which slowed inflation. Globalization therefore helps to explain the “Global Disinflation”, the phenomenon of decreasing inflation levels, in the last 20 years.
From 1990 to present, tariff rates around the world have declined continuously in a worldwide push to liberalize trade. As a result, trade has surged. The share of imports and exports in GDP increased from a global average of 38% in 1990 to 54% in 2005. While the causal link between tariff rates and trade is straightforward, there has been another and perhaps more surprising development. In the same period inflation fell from an average of 26% to a mere 4%, a trend called “Global Disinflation”. Figure 1 illustrates the parallel movement of tariff rates and inflation.
Figure 1.Development of tariff rates (bold line) and inflation (dashed line), world averages
While these basic facts are widely known, Figure 2 reveals some interesting aspects behind them. It shows the cross country distribution of inflation across 123 countries for a given year and then compares the distribution over four different years: 1980, 1990, 2000 and 2010. This reveals three important features. First, since deflation is very rare, inflation values become strongly concentrated on values close to zero. Second, all world regions are affected so the development is not driven only by a few economic “heavyweights”. Third, the change occurs continuously over the entire period of 1990 to 2010, there is no jump in levels
The effect of trade on productivity
In order to understand the mechanism linking these two observations we can resort to trade theory. Trade and inflation are linked through the effect of trade on productivity. International trade increases competition and thus gives an advantage to efficient firms. The theoretical understanding of the selection of the most efficient firms has been pioneered by Melitz (2003).
Based on the Melitz model, Schwerhoff and Sy (2013) build a model which describes how decreasing tariff rates increase the openness to trade and how this affects inflation. The increased competition benefits the most efficient firms. Efficient firms have on average lower prices than inefficient ones, so that prices increase more slowly when increasing trade forces the least efficient firms out of the market.
Independently from changes in trade openness, firms innovate and improve their productivity. This increase in productivity reduces the price of goods relative to wages. Increases in openness reinforce this process by eliminating the least efficient firms and allowing the efficient ones to replace them.
Changes in productivity and inflation
Changes in productivity affect relative prices. This means for example that increases in productivity reduce the cost of goods compared to the average wage (the price for labor). Inflation, however, is a monetary variable; it describes the development of the level of prices. An increase in both wages and good prices can leave the relative price unchanged.
So how does a change in productivity link to inflation? Friedman (1970) writes “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Inflation is thus largely in the hands of central banks since they control the quantity of money. Globalization, however, increases the efficiency of the economy, which allows firms to produce more output. If the central bank does not increase the quantity of money in response to this additional growth in output, inflation decreases.
This is why, according to Rogoff (2003), the universal nature of the fall in inflation seen in Figure 2 “invites us to open our minds to the possibility that other factors [than monetary policy] have also been significant”. Even countries where central banks were not in a strong position to fight inflation, it has fallen. But while not all central banks are in a position to effectively fight inflation, all countries are affected by the increase in trade.
Our research points out that increasing trade openness can be used to tackle high levels of inflation. Liberalizing trade policies thus provides a windfall gain for controlling inflation. The central bank could make use of this by actively stabilizing it at the lower level through complementary use of monetary policy.
On the reverse, the effect on inflation only works as long as openness keeps increasing. Since competition and the corresponding pressure on prices keeps increasing only as long as higher levels of openness are reached, the effect subsides as soon as openness stabilizes. For the past 20 years, openness did keep on increasing, but this development must come to a halt at some point. If the central bank does not react to this, the lack of the downward pressure on prices will cause inflation to rise again. Prudent monetary policy thus requires keeping an eye on trends in openness.