Academic journal article Economic Inquiry

HAS THE RISE IN GLOBALIZATION REDUCED U.S. INFLATION IN THE 1990s?

Academic journal article Economic Inquiry

HAS THE RISE IN GLOBALIZATION REDUCED U.S. INFLATION IN THE 1990s?

Article excerpt

JUANN H. HUNG [*]

This article investigates whether increased globalization of the U.S. economy has helped hold down inflation in the 1990s. Based on several measures, we find that globalization has increased. Further, we find that import prices exert a greater impact on prices of products in industries faced with greater import penetration. High foreign excess capacity accounts for much of the recent decline in U.S. inflation. Our results suggest that the decline in inflation is explained by the interaction of increased globalization and high excess foreign capacity. Globalization by itself does not lead to less inflation, just greater sensitivity to foreign economic conditions. (JEL E3)

I. INTRODUCTION

Has the rise in globalization helped reduce U.S. inflation in the 1990s? Two hypotheses have been proposed for how the rise in globalization may have held down inflation. The first is the so-called competing-goods effect hypothesis, which contends that greater competition from foreign producers has limited the ability of domestic producers to raise prices. The second hypothesis maintains that excess capacity abroad has helped U.S. manufactures meet the robust domestic demand in the United States without straining domestic resources and pushing up inflationary pressures.

This article first lays out a general framework that integrates these two hypotheses and then investigates each of them empirically. We find evidence in support of both hypotheses. To examine the competing-goods effect hypothesis, we estimate panel data regressions to find whether import prices have indeed exerted a greater impact on product prices in industries that are faced with greater import penetration. The results are affirmative.

We study the second, more general hypothesis by making two inquiries. First, has the rise in globalization coincided with the breakdown of the traditional Phillips curve's ability to predict inflation that began in the early 1990s? That is, has the United States become considerably more open in the 1990s than in previous years, when the Phillips curve tracked inflation with reasonable accuracy? Second, has foreign capacity utilization played an important role, along with traditional explanatory variables, in predicting inflation?

Our empirical evidence suggests that the answers to both inquires are also positive. Most striking is the finding that, by including foreign capacity utilization in the estimation of a Phillips curve equation, almost all of the missing inflation--the difference between actual inflation and predicted inflation based on the traditional Phillips curve--since 1994 disappears.

Our findings suggest that the interaction of slack foreign economic conditions and greater openness to trade may have helped tame the U.S. inflation in the 1990s, but globalization alone has not permanently reduced the threat of recession or inflation. Indeed, greater globalization may even help increase inflation when the U.S. and foreign economic expansions are synchronized.

No single researcher has looked at all of the questions posed in this article, but each question has been investigated separately before. Krugman (1994, 1995) and Irwin (1996) have looked at whether the United States has become more globalized over the past decade. They find that trade with the rest of the world is not a significant or rapidly growing influence on the U.S. economy. The question of whether prices of foreign goods influence domestic prices through the competing-goods effect has been investigated by Swagel (1997). He finds a statistically significant but small impact in 10 of the 19 industries in his sample. Similarly, Slaughter and Swagel (1997) find that increased globalization has had only a modest impact on wages in industrialized economies. Finally, Orr (1994) and Tootel (1998) find very little or no impact of foreign capacity utilization on domestic inflation. …

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