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2 Literature Review
2.1 The Openness and Inflation
The relationship between inflation and openness is an important issue in macroeconomics. Romer (1993) uses the Kydland and Prescott (1977) and Barro and Gordan (1983) model to explain the negative relationship between trade openness and inflation. He argues that greater openness will reduce the sacrifice ratio. Thus, policy makers have reduced the motive of mone-tary authorities to pursue expansionary monemone-tary policy. In addition, surprise monetary expansion leads to real currency depreciation. When inflation is measured in terms of a consumer price index and if nominal wages are flexible or the foreign goods are used as inputs in domestic production, the effect of the depreciation on the domestic price of imports will raise the domestic firms’
costs. Due to the influence of a real currency depreciation, the output gain to a given monetary expansion will be reduced and thus the Phillips curve is likely to be steeper in relatively open economies. Based on the time inconsistency model by Barro and Gordan (1983), this would lead to a lower inflation rate.
Romer (1993) uses cross-sectional data from 114 countries in 1973-1988 to deal with his empirical work. He finds that a higher trade openness was associated with lower inflation. When central bank independence and political instability are added to the empirical model, the negative openness-inflation relationship is much stronger in countries that are less stable and have a less independent central bank. Romer (1993) also uses a variety of subsamples to work with this empirical work. For example, when he eliminates the countries in which their mean inflation is greater than 30 percent, the negative effect of inflation on trade openness becomes weak. Moreover, when he classifies the full sample according to different regions and OECD countries, there is no evidence that the coefficient of trade openness is significant. Furthermore,
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Romer (1993) shrinks the sample to eighteen highly developed countries, and he finds that the coefficient of trade openness is insignificant.
Lane (1997) provides further research to relate trade openness and time consistent inflation. Romer (1993) argues that the more open countries tend to gain less from surprise monetary expansion. This explanation applies only to countries which are large enough to affect the structure of international relative prices. Lane (1997) establishes a general equilibrium model along with the time inconsistency model of Kydland and Prescott (1977) and Barro and Gordan (1983) to show that the inverse relationship of openness and inflation holds even for economies which are too small to affect the structure of international relative prices. Moreover, he uses the same sample of Romer (1993) to build on his empirical work, and the empirical results support the argument that the relationship between trade openness and inflation is negative. After the country size is held constant, Lane (1997) finds that the effect of trade openness is even stronger in OECD countries and in eighteen highly developed countries than in the full sample. The strength of the empirical results suggests that trade openness plays an important role in determinating the inflation rate in the long-run.
Terra (1998) divides the sample of Romer (1993) into four groups accord-ing to the indebtedness level, and she splits the period into a pre-debt crisis period (1973-1981) and a debt crisis period (1982–1990). Her empirical re-sults show that a negative relationship between trade openness and inflation only exist in the severely indebted countries during the debt crisis period. To differ from Romer (1993), Terra (1998) indicates that “the negative relation-ship between openness and inflation may be largely driven by the response of severely indebted countries to the debt crisis of the 1980s.” She brings up two explanations for the empirical results. One interpretation is that the severely indebted countries have a higher probability to violate the pre-commitment
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in monetary policy, and thus the time inconsistency problem becomes more serious. This explains why the negative effect of trade openness is only signif-icant in severely indebted countries. Another explanation is that the absence of pre-commitment in monetary policy generates a relationship of openness and inflation, and the severely indebted countries strengthen this relationship.
Additionally, Terra (1995) generates a model for further arguments. If there are two countries with the same debt situation, the less open country needs a larger exchange rate devaluation to obtain a trade surplus. Therefore, when the inflation tax is the major mechanism for resource transfer, the less open countries have higher inflation during a debt crisis.
Bleaney (1999) contrasts the relationship between trade openness and in-flation in the period of 1973-1988 with the period from 1989-1998. According to his empirical results, the negative relationship between trade openness and inflation become weak and insignificant since 1989. But Bleaney (1999) doesn’t explain why the negative relationship between trade openness and inflation is no longer robust after 1989. Furthermore, Bleaney (1999) uses the exchange rate regime data used by Ghosh er al. (1995) to catch on the exchange rate regime effect, and the positive coefficient of the exchange rate regime implies that a shift towards flexibility is associated with a higher inflation rate. Af-ter considering the role of the exchange rate regime, the coefficients of trade openness are significantly negative in 1973-1988 but insignificant in 1989-1998.
Since the exchange rate regime is such a significant variable, Bleaney (1999) argues that it needs to be considered more deeply. He concludes that because of the globalization of the international capital market, the pegged exchange rate regime is faced with more speculative challenges than ever before. In con-trast to the period of 1973-1988, developing countries need to find a way to combine flexible exchange rates with low inflation.
Gruben and McLeod (2004) apply the generalized method of moments
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(GMM) dynamic panel methods issued by Arellano and Bover (1995) to their empirical work, and they use the five-year average data for 1971-2000 which cover the periods from 1973-1989 for Romer (1993) and Terra (1998). Fol-lowing Terra (1998), they separate the countries according to their degree of indebtedness and separately split the period into the 1980s debt crisis and other periods. Consistent with Terra (1998), their pooled ordinary least square (OLS) estimates reveal that a negative relationship between trade openness and inflation of severely indebted countries only exist during a debt crisis, but no severely indebted country is significant over all periods. But different from Bleaney (1999), the empirical results of Gruben and McLeod (2004) show that the negative relationships of openness and inflation have strengthened during the 1990s which is a bit surprising. They cite the interpretation of Romer (1993) to explain why openness might reduce inflation.
Although the long-run effect of trade openness can be examined by using cross-sectional data, Alfaro (2005) tests whether a negative relationship be-tween trade openness and inflation exists in the short-run. She takes a panel data set from 1973 to 1998 into account. After controlling for the country fixed effect and time fixed effect, her empirical results show that the coeffi-cient of trade openness is positive which is inconsistent with Romer (1993).
Furthermore, Alfaro (2005) controls for high inflation episodes (average infla-tion greater than 50%), low inflainfla-tion episodes (average inflainfla-tion less than 2%), and a high openness sample (imports as a percentage of GDP greater than 100%) and finds that the effects of trade openness on inflation are significantly positive. According to her empirical results, she argues that greater open-ness does not reduce the motive of monetary authorities for inflation. Thus, Alfaro (2005) began to ask what other mechanisms might limit the benefits of unanticipated monetary expansions in the short-run. Based on Calvo and Vegh (1999), the economies with more open systems will have a more
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cient mechanism for pegging the exchange and reducing inflation. In addition, Frankel (1999) emphasized that the fixed exchange rate can reduce the transac-tion costs and the exchange rate risks can discourage trade. Therefore, Alfaro (2005) brought an exchange rate regime into the empirical work, and the coeffi-cient of openness is also positive and significant. More importantly, she found that the exchange rate regime has a negative effect on inflation when using the exchange rate regime which was defined by the International Monetary Fund (IMF) and Reinhart and Rogoff (2003). The empirical results show that when the exchange rate regime moves from floating to fixed, the inflation will fall. According to the empirical results, Alfaro (2005) believes that the fixed exchange rate regime plays a more important role than openness to influence inflation in the short-run.
Recently, Nasser, Sachsida, and Mendonca (2009) try to verify that more open economies can reduce inflation. They explore the relationship between trade openness and inflation in 152 countries during the period of 1950-1992 and find that the principles of Romer (1993) hold when using panel data.
Moreover, they also restrict the data set to the full period (1973-90), the pre-debt crisis period (1973-81), and the pre-debt crisis period (1982-90) and split the whole data set into four groups: severely indebted countries, moderately indebted countries, less indebted countries and other countries to test the hypothesis of Terra (1998) that the negative relationship is due to the severely indebted countries during the debt crisis period. However, different from the findings of Terra (1998), the negative relationship between trade openness and inflation is realized not only in severely indebted countries but also in other countries during the full period. These findings support the model of Barro and Gorden (1983) who argued by Romer (1993): more open economies should have lower inflation rates. An absence of a pre-commitment in monetary policy will lead to inefficiently high inflation.
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Lin and Chen (2010) use the panel data in 1973-2007 to explore the rela-tionship between openness and inflation. They argue that the characteristic of inflation is right-skewed and it will be influenced by outliers, so they apply QR for panel data of Koenker (2004) to their empirical work. After they do the empirical work between openness and inflation with QR, they find that when the quantile is higher the negative effect of openness on inflation be-comes stronger. Furthermore, when they add the exchange rate regime to the empirical work between openness and inflation, they find that the negative relationship between openness and inflation is not affected by exchange rate regime.