Globalization and inflation: The role of China

In this paper, we develop a theoretical model which identifies four channels -- import prices, competition with domestic suppliers and workers, and commodity prices -- through which price- and wage-setting conditions in country j may affect inflation in country i. We estimate a dynamic inflation equation derived from the theoretical model using a quarterly dataset of eighteen Organization for Economic Cooperation and Development (OECD) countries over the 1984-2006 period. Although our methodology can be applied to any pair of countries, we focus on the effect of China on the inflation rate of other countries. Our results suggest that while China's negative effect on global inflation has been quantitatively modest, it has increased in absolute terms since the early 2000s. We also find evidence that, for most countries examined, competition with domestic suppliers has been the most important channel.

The widely accepted view is that inflation is a monetary phenomenon (McCandless and Weber 1995), ultimately determined in the long run by monetary policy (Ball 2006). This suggests that institutional changes leading to better monetary policy frameworks may be the main explanation for the world-wide decline in inflation over the past decade. For instance, Carlstrom and Fuerst (2006) suggest that greater central bank independence accounts for about two-thirds of lower inflation outcomes among developed economies over the past two decades. Vega and Winkelried (2005) show that the adoption of inflation-targeting regimes has significantly reduced the mean inflation rate in a sample of developed and developing economies.

We directly test the relative importance of monetary policy credibility and central bank independence on the decline of inflation globally against alternative measures of importance, including the rise of China as a global manufacturing hub and the resulting decline in imported goods prices in many industrialized countries.