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ABSTRACT
This paper examines the impact of exchange-rate movements on inflation in eight Asian countries. Results from an open-economy Phillips curve are; first, the Markov-switching open-economy model confirm that the two-state Phillips curve outperforms alternative models to study inflation dynamics. There is considerable heterogeneity in the pass-through estimates for Asian countries, with Singapore exhibiting the lowest exchange rate pass-through (ERPT). Regime-dependent pass-through estimates are sensitive to average inflation and it should be factored in when forecasting inflation rates. Second, the extent of pass-through is considerably lower and far from complete in a low-inflation regime, endorsing Taylor hypothesis. Third, in the majority of the countries, we find support for global disinflation in domestic inflation that has strengthened over time. The main takeaway is that globalization matters for Asian inflation dynamics.
Acknowledgments
The authors would like to thank the Editor, Professor Ali M Kutan and two thoughtful reviewers of this journal for their comments/suggestions that helped to improve the content and exposition of this paper. The usual disclaimer applies.
Disclosure statement
No potential conflict of interests were reported by the authors.
Notes
1. The exchange rate could narrow down large imbalances in trade and foreign capital inflows (external imbalances). It is less effective if the extent of the pass-through is relatively small.
2. Exchange rate shocks in emerging markets tend to feed into local inflation at a much faster rate than in developed markets.
3. Empirical studies suggest that pass-through effects are neither complete nor the same across different economies. The literature generally agrees that ERPT is higher in emerging markets than the ones from DMs.
4. Both are consistent with the theoretical literature. Like openness, greater trade freedom improved market competition. Borrowing phases in Brun-Aguerre, Fuertes, and Phylaktis (Citation2012), the positive output gap-ERPT asymmetry relation denotes that exporters may act to enhance market share in fast growing economies. Larger market size induces stronger competition.
5. Ben Cheikh-Rault’s finding also raised questions on the effectiveness of exchange rate as a tool to correct trade balances and prevent deflation threats when a financial crisis hits the economy.
6. In the context of developed markets, observers find that globalization has led to decline in domestic inflation rates and this is because of the integration of low-wage, low-cost countries (China and India) into the global economy. Global output gap has replaced the domestic output gap as the key driver for inflation in the advanced and emerging economies.
7. Globalization in goods and financial markets is one of the main drivers of the disinflation process and could weaken the central banks’ abilities to control inflation (Yellen Citation2006).
8. They considered quarterly data in the analysis and noted that without these control variables, import elasticities in EMs rise to 41%, which is not substantially greater that the estimated 35% for DMs.
9. Credibility and low inflation are the two major characteristics of the IT regime. In de Mendonça and Tiberto (Citation2017), the authors present evidence based on a panel of 114 developing countries. They highlight the importance of keeping inflation expectation low and stable to reduce the pressure of inflation and its volatility due to ERPT. Central bank credibility can be an important tool to eliminate the pass-through effect on inflation.
10. For EMs, Caselli and Roitman (Citation2019) using local projection techniques have shown that ERPT is equal to 0.18 and 0.25 for depreciation of 0.10 and 0.20, respectively. For the five-founding member of Southeast Asian nations (ASEAN-5) countries, Anh et al. (Citation2018) find some heterogeneity in their pass-through estimates.
11. The rate of pass-through is around 0.66 for Greece when the yield difference is below 2.13%. Beyond the given threshold point, the sensitivity of import price reaches full pass-through.
12. Some authors prefer to use marginal (unit labor) cost instead of output gap as the main driving variable in the Phillip curve for tracking inflation dynamics. The advantage of using the latter is that it includes the impact of both productivity and wages on inflation. The potential superiority of the output gap over the marginal cost is discussed in Vašíček (Citation2011). Rudd and Whelan (Citation2007) argue that the theoretical case is weak and labor’s share version of the New-Keynesian model provides a weak description of the observed inflation behavior.
13. It relates to the theoretical literature on the global slack hypothesis that posits that it is global and not solely domestic economic slacks that drives local inflation. Statistical evidence supporting the so-called global slack hypothesis is mixed (Kabukçuoğlu and Martínez-García Citation2018).
14. The 22 OECD countries consists of Austria, Belgium, Canada, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, UK, USA, Japan, Finland, Australia and New Zealand.
15. All the countries under review are grouped under moderate inflation regime (2.76% to 8.28%) except for Japan and Singapore (less than 2.76%). Indonesia is the only country in the high-inflation group. For countries with moderate inflation, Ben Cheikh and Louhichi (Citation2016) find that one percent exchange rate depreciation causes the import price to increase by 0.66%, compared to only 0.47% for the low-inflation countries.
16. Besides these variables, institutional development, financial integration, and fiscal stability can reduce inflation and its volatility.
17. It may produce biased pass-through estimates misleadingly suggest an increase in pass-through.
18. These models are well established in the exchange literature; see Engle and Hamilton (Citation1990).
19. We notice that several equations suffer from autocorrelation even after adding an impulse dummy and a lag variable in the equation. We need to be cautious about this when interpreting the empirical results. Here we adopt robust standard errors to accommodate the issue.
20. The ‘good-luck’ hypothesis attributes globalization help to mute inflationary pressure around the world through a series of favorable external shocks. Rapid market integration of the low-cost economies acts to moderate inflation directly (lowering import prices and indirectly (via price competition).
21. Abbas, Bhattacharya, and Sgro (Citation2016) find weak support for the role of globalization in influencing inflation for the advanced economies. Studies in the past have focused on the linear estimation methods; see also in Chin (Citation2019) for the discussion to obtain robust estimates for the output-gap Phillips curve.
22. No evidence of global inflation in both short-run and long run during low (both) inflation regime for South Korea, Indonesia and Malaysia (Singapore and China).
23. Ardakani et al.’s (Citation2018) used data from 26 developed and 72 developing countries to examine the effectiveness of IT on inflation and volatility in both the IT (27) and non-IT (71) countries. They also look at the impact of IT on other macroeconomic variables such as level of government debts, the sacrifice ratio, interest rate volatility, and exchange rate volatility. With regard to exchange rate volatility, their results reveal an increase (decrease) in volatility of exchange rate for the DMs. They also noted that it enhanced fiscal discipline in both the advanced and developing countries.
24. There are indirect benefits associated with an IT regime. They include reduction in exchange rate volatility, fiscal discipline, and “dollarization”.
25. Sterilized interventions are used extensively by EMs and it refers to central bank purchases and sales of foreign assets to influence a nation’s exchange rate without influencing inflation. Sterilized interventions in the presence of capital control policies contribute toward macroeconomic stability by allowing central banks to reduce both inflation and exchange rate volatility under a floating exchange rate regime.
26. Results are available upon request from the authors.
27. Hellerstein and Villas-Boas (Citation2010) recorded only a weak evidence of declining ERPT over the past decades. The decline in ERPT is not genuine and should not persist over time. The flattening of the Phillips curve could be due to the effect of globalization. Improved monetary policy through the adoption of IT (or the transparency of monetary decisions) reduces the sensitivity between inflation and the domestic output gap.