Testing monetary policy intentions in open economies.

• Author: Granato, Jim

1. Introduction

   This article examines the relationship between economic openness and inflation performance. Among the most prominent research on this topic is the work by Romer (1993). He demonstrates a negative relationship between economic openness and the inflation level. His finding has also been viewed as supportive, albeit indirectly, of time consistency theory (Kydland and Prescott 1977). (1) Romer (1993) argues that policymakers in more open economies have less incentive to adopt an expansionary monetary policy. His argument is based on the assumption that monetary surprises in more open economies result in higher inflation for a given increase in output. Romer's finding that more open economies have lower inflation levels leads him to infer that this is evidence of time consistency in monetary policy practices.

   However, Romer's work has not been generally accepted. Temple (2002) provides evidence that the openness-inflation correlation does not stem from time consistency theory because the inflation level may not properly reveal the monetary authorities' policy intentions. Temple questions this inference because it starts from a strong but unjustified assumption--more open economies possess a relatively steeper Phillips curve. Consequently, Temple proposes that the examination of the positive relationship between openness and the slope of the Phillips curve is a fundamental condition for Romer's argument. He, however, finds little support for the positive relationship between economic openness and the slope of the Phillips curve.

   Further work on the relationship of openness and monetary policy intentions comes from Clarida, Gali, and Gertler (2001, 2002; hereafter CGG). In CGG (2001), the authors present a simple open-economy model with a Taylor-type interest rate policy rule (Taylor 1993). The article concludes that the optimal monetary policy in an open economy has the same solution as that in a closed economy derived in CGG (1999). The authors also suggest that there is a direct link between the degree of economic openness and the aggressiveness of monetary policy. They state that, "[O]penness does affect the parameters of the model, suggesting a quantitative implication.... [H]ow aggressively a central bank should adjust the interest rate in response to inflationary pressures depends on the degree of openness" (CGG 2001, p. 248).

   In subsequent work, CGG (2002) revisit the issue based on a dynamic open-economy New Keynesian model and the role of monetary policy in open economies is refined. Consistent with the argument in CGG (2001), they find that the optimal monetary policy rule in an open economy is isomorphic to that in a closed economy in the Nash equilibrium. They also suggest that openness does not affect the optimality of a policy rule in such a scenario. On the other hand, economic openness does affect optimal monetary policy when the foreign optimal policy is endogenous in the domestic country's objective function. This effect, however, is ambiguous in direction because the relationship between the degree of economic openness and the aggressiveness of monetary policy is determined by the relative size of trade and wealth effects of changes in foreign output.

   This line of theoretical literature is limited and does not offer a definitive conclusion on the relationship between economic openness and monetary policy intentions. Our article provides an alternative empirical evaluation of the relationship. Based on prior literature, we use inflation variability and persistence as the measures of monetary policy intentions. One branch of the literature, such as Taylor (1999), CGG (2000), and Owyang (2001), argues that aggressive monetary policy reduces the volatility of inflation. For instance, CGG (2000) estimate a forward-looking Taylor rule for the period between 1960:I and 1996:IV. They use Paul Volcker's appointment as Chairman of the Federal Reserve System as a regime shift to a more aggressive anti-inflation policy stance. Their results show that the policy rule is significantly more aggressive in the post-Volcker period, which reduced inflation volatility substantially. Another branch of the literature examines how monetary policy affects inflation persistence (Fuhrer 1995; Fuhrer and Moore 1995; Siklos 1999; Owyang 2001). For example, Siklos (1999) studies the effect of inflation-targeting policy on the persistence of inflation in a group of inflation-targeting countries in the period of 1958:I-1997:IV.

   The issue of whether monetary authorities in more open economies are more aggressive about ensuring inflation stability remains unsettled. The focus of this article is to provide an empirical assessment of the openness-inflation relationship that is based on monetary-policy implementation. We demonstrate the relationship between economic openness and two new variables, inflation variability and inflation persistence. These two variables are used to potentially reveal monetary policy making intentions. Using a sample of 102 countries for the period 1949-200l, our results show that economic openness is negatively associated with inflation volatility and persistence. In particular, we find that this relationship is most evident in the 1990s. This result is robust after controlling for various factors that may affect the policymakers' aggressiveness in stabilizing inflation. These factors include the size of an average supply shock an economy confronts, the status of economic development, the level of inflation, and the size of a country.

   We also examine potential differences between developed and developing countries. We find that this negative relationship between openness and inflation performance is more pronounced in developed countries. The evidence further suggests that the developed and more economically open countries have experienced less inflation volatility and persistence since the 1990s. Our results suggest that the near-universal regime shift in 1990 is not just a simple process of increased policy aggressiveness. We note that the recent emphasis toward more aggressive monetary policies is, in part, a response to economic openness.

   We organize the rest of our article in four sections. Section 2 presents the empirical results on the relationship between openness and inflation volatility. Section 3 provides the estimation procedure and examines the relationship between openness and inflation persistence, and Section 4 concludes the article.

2. Preliminary Evidence

   Several studies show that aggressive monetary policy reduces both inflation and output volatility (Taylor 1999). We use the variance of inflation ([[sigma].sup.2.sub.[pi]]) to measure inflation volatility. Our conjecture is that, if there exists a positive relationship between an aggressive inflation-stabilizing monetary policy and economic openness, we would expect to observe a negative relationship between openness and the variance of inflation. This relationship would serve as preliminary evidence of a positive relationship between an aggressive inflation-stabilizing monetary policy and economic openness.

   Sample and Data

   We use quarterly data from the International Monetary Fund's (IMF) International Financial Statistics (IFS). The percentage change in the Consumer Price Index (CPI) is used as the measure of inflation ([[pi].sub.t]). For each country, we include the maximum data length available from IFS for the period 1949-2001. (2) We exclude any country whose data starts later than 1989. The average length of the data in our sample is approximately 39 years. The longest (shortest) duration is 53 (12) years. Overall, we have 102 countries to start our empirical analysis. (3)

   Economic Openness and Inflation Volatility

   To assess the relationship between openness and inflation volatility across countries, we estimate the following regression:

   log([[sigma].sup.2.sub.[pi]i]) = [alpha] + [beta][X.sub.i] + [[epsilon].sub.i], (2.1)

   where [[sigma].sup.2.sub.[pi]i] represents the variance of country i's inflation rate; as used in Romer (1993) and Frankel and Rose (1996), [X.sub.i] is the ratio of imports of goods and services to GDP (as a measure of the degree of openness); and [[epsilon].sub.i] is a stochastic term. As in Lane (1997), we take the logarithm of the inflation variance to reduce the effect of extreme observations on the results of regression 2.1. (4)

   We start our analysis with the whole sample period (1949-2001). Figure 1 presents a scatter plot of the fitted values for the volatility of inflation against the level of economic openness for each country. The figure shows an overall negative relationship between openness and the volatility of inflation. We report the associated results in regression (1) of Table 1. The openness coefficient is negative (-.015) and significant (t = - 3.493) for the whole sample period.

   [FIGURE 1 OMITTED]

   The substantive implications of these findings are straightforward: Increasing economic openness generates less inflation volatility. Examining these results further, we see in relation to the sample average of inflation volatility of 1.920 (logarithmic scale), a 1 SD increase in economic openness (equivalent to 23 percentage points) decreases inflation volatility (on average) by almost 18%. (5) To put it differently, in an economy with a level of openness of 10%, one would expect its inflation volatility to be 2.327. If economic openness, over a period of time, increased to 50% and later to 100%, the inflation volatility would drop to 1.727 and 0.977, respectively.

   How sensitive is this negative relationship to different time periods? The breakdown of the Bretton Woods system in 1973 provided a higher degree of domestic flexibility in monetary policy across countries, and researchers often acknowledge that the theoretical predictions of monetary models may have different results under the floating exchange-rate regime (post-1973). Further, the recent...