Can Domestic Policies Influence Inflation?

IMF Working Papers, November 1, 2007

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Globalization reduces domestic pressures on inflation and reduces the scope of domestic authorities to influence the pace of inflation.
As markets integrate, common, cross-border sources of inflation increase, reducing the extent of domestically-generated inflation.
Using a methodology identifying common time and sectoral trends, this reduction in domestically-generated inflation is especially the case in the countries of the eurozone, with their longer histories of product market integration.
The domestically-generated component of inflation may be difficult to manipulate because policies act, especially in the short run, mainly through managing domestic demand.
The relationship between domestic demand (proxied by the output gap and unit labor cost growth) and inflation has been weak, constrained in part by trade openness.
The domestic component of inflation contains a country-specific international catch-up process that generates price equalization across countries; evidence indicates catch-up has accelerated with increasing market integration.
For eurozone economies, there may be limits on the use of fiscal and labor market policies to contain inflation.
New member states may lack policy leverage to meet the Maastricht inflation limit necessary for entering the eurozone.
Case studies show that fiscal consolidation needed to comply with the inflation criterion can be large and sustained only briefly to get under the Maastricht wire.

Global market integration increases common cross-border inflation sources and reduces domestically-generated inflation.
Domestic policies influence inflation primarily by affecting domestic demand; the proxies used are:
- output gap
- unit labor cost growth
Trade openness constrains the pass-through from domestic demand and labor cost movements to inflation.
A country-specific international catch-up process within the domestic inflation component drives price convergence across countries; this process has accelerated with market integration.

Fiscal and labor market policies may have limited effectiveness in containing inflation in integrated markets, notably within the eurozone.
Meeting the Maastricht inflation criterion through domestic policy may require:
- large fiscal consolidation
- consolidation that can be maintained only briefly to meet the criterion
New member states aiming for EMU accession face limited policy leverage to hit the Maastricht inflation limit via conventional domestic demand management.

Subject: Foreign exchange, Inflation, Labor, Labor costs, Nominal effective exchange rate, Output gap, Prices, Production, Taxes, Value-added tax
Keywords: business cycle, catch-up process, convergence effects in the eurozone, EMU accession, Euro adoption, Europe, eurozone country, eurozone economy, eurozone sample, exchange rate, fiscal policy, Globalization, Inflation, inflation criterion, inflation increase, inflation term, labor cost movement, Labor costs, Maastricht criterion, Maastricht inflation criterion, money market, Nominal effective exchange rate, Output gap, Phillips curve, Price convergence, rate of inflation, Value-added tax, WP