Inflation dynamics and Globalization: Evidence from India

Syed Kanwar Abbas*

Abstract

The foreign resource capacity (globalization) affects inflation and real

economic activity. This paper shows that for a fast growing economy of India,

the foreign resource capacity has reduced inflation rate and changed the

process of inflation dynamics when globalization increased, as related to trade

liberalization policy in 1991. These results yield important policy implications

for the conduct of monetary policy.

Key words. Foreign resource capacity; Globalization; Inflation dynamics; New Keynesian Phillips Curve; India.

JEL Classification: E31, F41, F62

*Correspondence: Xi’an Jiaotong Liverpool University, International Business School Suzhou, 111 Ren’ai Road, Suzhou, Jiangsu, China.Email: Syed.Abbas@xjtlu.edu.cnPhone +86 (0) 512-8816-1670

Inflation dynamics and Globalization: Evidence from India

1. Introduction

The increasing role of foreign resource capacity (globalization) in

inflation process affects the ability of a central bank to stabilize inflation and

output gap. The recent theoretical contributions, in particular Woodford

(2007), discuss the impact of foreign resource capacity on inflation and

domestic output as well as the subsequent role of monetary policy in this era

of globalization. The empirical evidence for and against the sensitivity of

inflation to the foreign resource capacity is also equally emerging over time

(see Mishkin (2009) for discussions).

For a fast growing developing economy of India, the trade

liberalization policy was introduced in 1991, which increased an access of the

Indian firms to new imported inputs and increased their productivity and

performance leading to domestic product growth [Pinelopi K Goldberg et al.

(2010a; 2010b)].† This openness to trade policy is an important channel

through which the foreign resource capacity can affect the dynamics of

inflation and output. The reduction in imported intermediate input prices due

to increased globalization has direct impact on the marginal cost of domestic

firms. The reduction in the marginal cost decreases the overall price level. In

this context, the data show that inflation in India has significantly reduced

† India has important linkages with the global economy and for discussion see Rada andArnim (2014).

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from the early 1990s, and one of the plausible explanations, which we focus

on, is the potential effect of foreign resource capacity on inflation dynamics.

The earlier studies did not focus on the effect of foreign resource

capacity and it is believed that inflation dynamics cannot be explained by the

Phillips curve relationship, e.g., Phillips curve does not ‘exist’ for India (Paul

(2009)).‡ In this paper, we analyse the impact of foreign resource capacity on

inflation process by estimating a Phillips curve, which incorporates the impact

of foreign resource capacity on firms’ pricing behaviour. As a result, the

estimated reduced form parameters are micro-founded based on the ‘deep’

structural parameters and represent the optimal behaviour of economic agents.

The reduced-form equations of the New Keynesian Phillips curve, as

based on Woodford (2007), are estimated using empirical approach of the

generalized method of moments (GMM), which also takes into account the

potential endogeneity problem. The model is estimated over two different

sample periods, 1970-1990 and 1991-2009, respectively. The second sample

period covers the period when India started trade-liberalization policy and the

process of globalization increased over this sample period.

The results show that the foreign resource capacity affects inflation

process and has brought down inflation rate in India. The feedback from the

foreign resource capacity on the real economic activity describes inflation ‡ In macroeconomic theory, the Phillips curve is an important tool that is used to analyse

monetary policy and short-run process of inflation dynamics and is also widely used by the

central banks.

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dynamics, such as the foreign resource capacity affects inflation through

domestic output gap. The estimate of foreign resource capacity increases over

the second sub-sample period. This shows change in inflation process, and

inflation is also low and more stable after 1991. Inflation dynamics are

forward-looking and the lagged inflation does not drive current inflation. This

suggests that economic agents (firms) are forward looking in decision-making.

Our findings provide important policy implications. In particular, these

results are related to the conduct of monetary policy and suggest that the

central bank (the Reserve Bank of India) should consider the role of foreign

resource capacity to stabilize inflation and real economic activity (domestic

output gap) and also respond to the volatility of output, respectively. As

inflation is determined by the foreign resource capacity, this may affect the

ability of central bank to stabilize price level and full employment.

The paper is organized as follows. The theoretical model and

estimation framework are discussed in section 2. Section 3 discusses the data

construction while the results are discussed in Section 4. This is followed by

concluding remarks in section 5.

2. The model and estimation approach

The foreign resource capacity (globalization) affects real activity (i.e.,

domestic output) through trade integration, financial markets and also factor

markets (i.e., easy mobility of labour). This yields significant impact on price,

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profit and productivity of the domestic firms. Inflation process is determined

by both the domestic output gap and the foreign output gap as follows [see

Woodford (2007) for derivation].

π H ,t=βE t π H ,t +1+λH xd , t+λF x f , t+εt (1)

Where π H ,t is the domestic goods inflation, and where xd , t and x f , t are current

domestic output and foreign output, respectively. The ^ (hat) shows deviation

from the steady state approximated by the trend.ε t is an exogenous disturbance

term, which includes technology and preference shocks.β is the discount

factor.λH measures the sensitivity of inflation to the domestic output gap, and

where λF measures the sensitivity of inflation to the foreign output gap. The

reduced form coefficients (λH andλF ) are derived from the structural

equations that represent consumers and produces optimal choices.

Equation (1) captures the direct impact of foreign resource capacity on

domestic inflation. The foreign resource capacity also affects the current

domestic output and potential output of an economy. A few studies [Milani

(2010) and Zaniboni (2008)] discuss an indirect effect of the foreign resource

capacity on inflation through domestic output. To capture an indirect impact of

the foreign resource capacity on inflation, the aggregate output is defined by

the weighted average of both the domestic output and the foreign output.§

§ Zaniboni (2008) introduces the domestic output gap as a weighted average of both the

domestic output gap and the foreign output gap.

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π H ,t=βE t π H ,t +1+λ x t+εt (2)

xt=(1−h) xt , d+h xt , f +ζ t (3)

In this case, equation (3) shows the feedback from the foreign resource

capacity on the real activity. ** The weight (1-h) attached to the domestic

output gap shows bias in home consumption.ζ t may include other shocks (for

example interest rate through monetary policy and exchange rate through

competitiveness) on the domestic output,x t .

As a first step, the ordinary least squares (LS) is used while the

expected future inflation,π H ,t +1 , is endogenous and determined by other

macroeconomic fundamentals, e.g., interest rate. LS can produce biased and

inconsistent estimates. The generalized method of moments (GMM) is applied

to estimate equation (1) and (2), respectively. Under the assumption of rational

expectations, the errors in the forecast of,π H ,t +1 , are uncorrelated with

information t and earlier time periods. This can provide the following

orthogonality condition for equation (1).

Et {(π H , t−βπ H , t+1− λH xd , t−λF xf , t ) zt }=0

(4)

** The domestic output,x t , is endogenous and a few studies (Bardsen et al. (2004)) also

introduce the feedback from the lagged inflation on xt .

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Where zt is a vector of instruments and includes four lags each for inflation,

domestic output gap, foreign output gap and discount rate (percent per

annum).†† By substituting equation (3) into (2), the orthogonality condition for

equation (2) can also be written accordingly.

3. The data

Our sample period depends on the availability of the Indian data and

her trading partners’ data, which are used to construct the measure of foreign

resource capacity (foreign output gap). For India, the quarterly data of relevant

indicators (e.g., GDP deflator) start from 1996.‡‡ The quarterly data for major

Indian trading partners are not available in most cases, e.g., Saudi Arabia and

United Arab Emirates do not have quarterly data.§§ As a result, the annual time

series data ranging from 1970 to 2009 after sample adjustment is used in

estimation. The following variables are used.

The data on bilateral exports and imports of India with her respective

major trading partners are obtained from Direction of Trade Statistics. The

data on inflation and the real gross domestic product (GDP) at constant 2005

†† Instruments are valid and relevant based on Hansen J statistic and first-stage F-stat in all the

regression specifications.‡‡ The theoretical model, equations (1) and (2), relate domestic goods price inflation to

domestic output gap and foreign output gap. As a result, we focus on domestic goods price

inflation rather than consumer price inflation in empirical analysis.§§ We include ten largest trading partners, which are Belgium, China, Hong Kong, Germany,

Netherlands, Saudi Arabia, Singapore, United Arab Emirates, the United Kingdom and the

United States.

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prices (US dollar) are obtained from the United Nation’s Database. The

domestic output gap is calculated as the deviation of (log) real GDP from a

polynomial quadratic time trend. Following earlier studies (Borio and Filardo

(2007) and Ihrig et al. (2010)), the foreign output is constructed as a weighted

average of the real GDP of the trading partners, and the trade-weights are

calculated using imports and exports of trading partners. The foreign output is

defined by y f , t=∑

j=1

10

w tj y t

j

and, where

w tj=

Exportstj+Importst

j

∑j=1

10

( Exportstj+ Importst

j ).We use one period lagged

time varying trade weights,w t−1j

, to avoid potential endogeneity. Like the

domestic output gap, the foreign output is also de-trended with a fitted

quadratic time trend. The movements in the domestic output gap follow the

foreign output gap especially in the early 1990s when the trade liberalization

policy was introduced in India (see figure 1).

4. The results

The results with GMM by substituting equation (3) into (2) (ignoring

constant) yields

π H ,t=0. 692 π H , t+1−0 .193 [0 .769 { xt ,d+0 .231 { xt , f ]+ε t ¿ (0 .041) (0. 041) (0 . 068 ) ¿GMM, Hansen's J chi2(13 ) = 3 .85 [0 .99 ] ¿ Sample period after adjustment: 1970-2009 ¿¿The estimates are efficient and robust for arbitrary heteroskedasticity and

autocorrelation. The heteroskedasticity and autocorrelation-robust (HAC)

standard errors based on Bartlett kernel with lags chosen by the Newey-West

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method are reported in parentheses. According to these results, the foreign

resource capacity plays an important role in inflation process. If we estimate

over the sub sample when the trade liberalization policy was introduced in

1991, the share of foreign resource capacity increases from 0.23 to 0.89 and it

is also greater than the domestic output.

π H ,t=0. 810 πH , t+1−0 .138[0 .105 { xt , d+0 .895 { xt , f ]+ε t ¿ ( 0.018 ) (0 .033) (0 .19) ¿GMM, Hansen's J chi2(13) = 2.69 [0 .99 ] , ¿ Sample period: 1991-2009 ¿¿The coefficient on the foreign resource capacity is positive and statistically

significant in both the full and sub sample periods suggesting that the foreign

resource capacity is an important driving force of inflation. The other

important observation is that the coefficient on expected inflation (the discount

factor,β ) is increasing over time.β should lie between 0 and 1, and

empirically closer to 1 (i.e., 0.99). However, it is 0.81, as suggestively less

than one, which shows that economic agents place less weight on future

inflation in India. This shows a durable long run trade-off between inflation

and output gap (or unemployment). On the other hand, the increase in the size

of coefficient onβ from 0.69 to 0.81 also shows that inflation dynamics are

forward looking in India.***

*** We also estimated the hybrid new Keynesian Phillips curve with both future and lagged inflation to confirm these findings. The results are available upon request.

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Common to the full and sub sample results, the slope coefficient,λ , is

incorrectly signed (negative) and this finding is also robust if the share of

foreign resource capacity is considered zero (i.e., h=0 that yields the baseline

new Keynesian Phillips curve). There are different explanations for this, and

one of the arguments, as developed by Gali and Gertler (1999), is that the

output gap is not a good proxy for real activity compared to the marginal cost.

For India, the discussion either the marginal cost or output gap is a good proxy

for real activity is beyond the scope of the present paper. In particular, we find

that the negative sign onλ yields the incorrect sign (negative) on the

coefficient of foreign output gap, as observed below from the GMM estimates

of equation (1). This may produce incorrect conclusion that the share of

foreign resource capacity does not affect inflation dynamics.

π H ,t=0.654 π H , t+1-0 .255 { xt , d -0 .0721 { x t , f +εt ¿ (0 .036) (0. 0273 ) (0 .00932) ¿GMM, Hansen's J chi2 (15) = 2 .98 [0.99 ] , ¿ Sample period after adjustment: 1970-2009 ¿¿The heteroskedasticity and autocorrelation-robust (HAC) standard errors

based on Bartlett kernel with lags chosen by the Newey-West method are

reported in parentheses. The set of instruments is same as used before and

consists of four lags each for inflation, domestic output gap, foreign output

gap and discount rate (percent per annum). Contrary to the theoretical

predictions, the estimate of foreign output gap(-0 . 0721)and the estimate of

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domestic output gap( -0 .255)are incorrectly signed (negative) though both

these coefficients are statistically significant.†††

The foreign resource capacity has changed process of inflation

dynamics. In figure 2, we plot the expected inflation (as derived from the first-

stage regression fitted values from the regression of expected inflation at t+1

on instruments) and real economic activity (measured as fitted values from the

regression of domestic output gap on lagged domestic output gap and lagged

foreign output gap). It is observed that the increasing share of foreign resource

capacity in domestic activity from 1991 has affected inflation process and also

decreased inflation rate in India over time.

5. Concluding remarks

The foreign resource capacity affects inflation and real economic

activity. This paper provides an evidence that for a fast growing Indian

economy, the foreign resource capacity has reduced inflation rate and changed

the process of inflation dynamics when globalization increased, as related to

trade liberalization policy in 1991. These results suggest important policy

implications about the conduct of monetary policy, which should take into the

role of foreign resource capacity to stabilize domestic inflation and real

economic activity in India.

References††† The results are qualitatively similar over the sub-sample period (1991-2009) and are available upon request.

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Gali, J. & Gertler, M., 1999. Inflation dynamics: A structural

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FIGURE 1. INDIAN DOMESTIC GAP AND FOREIGN OUTPUT GAP-.3

-.2-.1

0.1

.2

1970 1980 1990 2000 2010t

India Output Gap India Foreign Output Gap

FIGURE 2. EXPECTED INFLATION AND REAL ACTIVITY

-.05

0.0

5.1

.15

1970 1980 1990 2000 2010t

expected inflation estimated output gap

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