Does Trade Openness Reduce Inflation? Empirical Evidence from Pakistan

Article excerpt

Abstract:

One of the more celebrated propositions found in international trade is the case that trade liberalization is associated with declining prices, so that protectionism is inflationary. In line with this view, Romer (1993) postulates the hypothesis that inflation is lower in small and open economies. The objective of this study is to examine Romer's hypothesis in Pakistan. For this purpose, we have used multivariate cointegration and a vector error correction model. The study covers the period from 1960 to 2007. The empirical findings under the cointegration test show that there is a significant negative long-run relationship between inflation and trade openness, which confirms the existence of Romer's hypothesis in Pakistan.

Keywords: Trade openness, inflation, cointegration, vector error correction model, Pakistan.

JEL Classification: C22, F41, O53.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

One of the more celebrated propositions found in every international trade text is the case that trade liberalization is associated with declining prices, so that protectionism is inflationary. In today's world, no developing country can afford to isolate itself from the world economy. The benefits of outward-looking policies that help in taking advantage of the possibilities of international trade and capital flows are extensively discussed in the literature. Economic liberalization, globalization, and openness became buzzwords in the 1990s. There has been a distinct shift in favor of greater integration of the world economy. This trend has been toward greater opening up and most developing economies have moved away from the typical closed economy structure.

Sustained low inflation has been a stylized fact of the late 1990s and early 2000s, both in advanced and increasingly in emerging markets. Some have argued that these developments could reflect stiffer global competition and the increased weight of developing countries in the global trading system (Rogoff, 2003). The relationship between inflation and openness has been the subject of research, theoretical as well as empirical. However, the literature on the subject is relatively scant. According to the 'new growth theory', openness is likely to affect inflation through its effect on output (Jin, 2000). This link could operate through: (i) increased efficiency, which is likely to reduce costs through changes in the composition of inputs procured domestically and internationally; (ii) better allocation of resources; (iii) increased capacity utilization; and (iv) a rise in foreign investment which could stimulate output growth and ease pressure on prices (Ashra, 2002).

When we review some of the existing empirical studies of the relationship between openness and inflation, we find inconclusive evidence suggesting that greater openness is associated with a lower trend in inflation. Romer (1993) finds that closed economies tend to have higher inflation. He argues that central banks in economies more open to trade find currency fluctuations caused by money surprises more painful and therefore exercise more restraint than their closed economy counterparts. Several studies have tested Romer's argument in different ways and have supported the conventional view of the negative relationship between trade openness and inflation. Thus empirical findings of Lane (1997), Ashra (2002), Sachsida et al. (2003), Yanikkaya (2003), Gruben and Mcleod (2004), Kim and Beladi (2004), Daniels et al. (2005), Razin and Loungani (2005), Aron and Muellbauer (2007), Badinger (2007), Bowdler and Nunziataz (2007) all validate Romer's argument. However, Terra (1998) only marginally supports Romer's argument by claiming that the negative correlation is only evident in severely indebted countries during the 1980s crisis period. Similarly, Batra (2001) argues that tariffs do not necessarily cause inflation, at least in the US. Gruben and Mcleod (2004) show that there does not exist any significant openness-inflation relationship among OECD economies. …