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Governor Frederic S. Mishkin

At the Domestic Prices in an Integrated World Economy Conference, Board of Governors of
the Federal Reserve System, Washington, D.C.
September 27, 2007

Globalization, Macroeconomic Performance, and Monetary Policy
In recent years, globalization has become one of the hottest topics, not only for the general public
but also for central bankers.1 Some commentators have gone so far as to claim that greater
openness of economies to flows of goods, services, capital, and businesses from other nations
invalidate traditional economic models of inflation, which take little account of globalization.
In the long run, monetary policy strives to achieve price stability, which contributes to maximum
sustainable employment and economic growth. In the shorter run, we at the Federal Reserve aim to
achieve our dual mandate of not only stabilizing prices but also reducing the volatility of output and
employment around their maximum sustainable levels. Globalization affects the ability of monetary
policy makers to stabilize prices and output in two ways: (1) through its effects on the behavior of
inflation and output and (2) through its effects on the ways in which monetary policy influences
inflation and output--that is, on the monetary transmission mechanism.
I will look at each in turn and will then use the analysis to address another important issue for
monetary policy makers: Has globalization been a key driver of improvements in inflation
performance and the decline in inflation that we have been seeing throughout the world?
(Please note that my comments here reflect my own views and not necessarily those of others on the
Board of Governors or the Federal Open Market Committee.)
Globalization and Inflation
We should never forget Milton Friedman's adage that "inflation is always and everywhere a
monetary phenomenon." In the long run, as long as a central bank has an independent monetary
policy--that is, it is not locked into a fixed-exchange-rate regime in which its hands are tied--the rate
of inflation is determined by monetary policy. Globalization, however, can have an effect on the
incentives for central banks to control inflation and, more directly, on inflation developments in the
short and medium runs.
Kenneth Rogoff (2003) argues that globalization has led to greater price flexibility, which has
reduced the ability of central banks to use inflation surprises to boost output. In other words, the
Phillips curve will steepen, making more stark the short-run tradeoff between unemployment and
inflation. As a result, central banks will be less tempted to try to exploit the short-run tradeoff
between inflation and unemployment, as in the Barro-Gordon (1983) model, and so will be less
likely to pursue overly expansionary monetary policy that leads to higher inflation. A major
problem with Rogoff's argument is that instead of steepening with the growth of globalization in
recent years, the Phillips curve has become flatter, not only in the United States but also in many
other countries throughout the world (Borio and Filardo, 2007; International Monetary Fund, 2006;
Ihrig and others, 2007; Pain, Koske, and Sollie, 2006). Therefore, even though Rogoff's argument is
reasonable from a theoretical viewpoint, it is hard to make the case that it is important in the current
economic environment.

Globalization, because it makes markets more competitive, also has the potential to spur
productivity growth. Higher productivity growth can lead to a reduction in inflation because it
directly lowers prices if monetary policy does not become more expansionary. In addition, such
growth makes it easier for the monetary authorities to allow inflation to fall because output growth
will continue to be rapid when inflation is declining. This may have been the situation in the United
States in the late 1990s, when productivity growth surged and inflation declined. The rise in
productivity growth during this period in the United States, however, did not seem to spill over to
other industrial countries, a result that cast doubt on whether globalization has indeed accelerated
the transmission of productivity growth across national borders.
Because globalization increases competition, it can also reduce markups (price over costs), and this
reduction may lead to lower relative prices, as is argued by Chen, Imbs, and Scott (2007). However,
lower markups and price levels should have only transitory effects on inflation. Furthermore, the
prediction of lower markups from globalization seems to conflict with the high corporate profit rates
that we are currently observing around the world.
These effects from the greater price flexibility and increased competition in domestic markets that
have arisen from globalization, while theoretically plausible, are often at variance with salient
features of the world economy, and so they do not explain why inflation has declined in recent
years. However, another very dramatic feature of globalization is that it has brought more than a
billion new workers into the global economic system from China and India. Some observers claim
that through its sales of low-cost goods, developing Asia--and especially China--has been "exporting
deflation" and will continue to do so until wages in these countries rise. Although this effect, too, is
plausible, research suggests that its importance should not be exaggerated.
If China were truly exporting deflation, the effect should be evident primarily in the behavior of
import prices. Research at the Federal Reserve Board by Kamin, Marazzi, and Schindler (2006)
estimates that purchases of manufactures from China have lowered U.S. import price inflation
roughly 1 percentage point annually over the past decade, a decline that has led to a short-run
lowering of consumer price inflation of about one-tenth of 1 percentage point and a somewhat larger
effect over the longer term. Research at the Organisation for Economic Co-operation and
Development (OECD) by Pain, Koske, and Sollie (2006) arrives at a similar estimate of the effect of
trade in manufactures with developing countries on U.S. inflation: negative 0.2 to negative 0.3
percentage point.
At the same time, the additional demand for primary commodities by developing Asia, especially
China and India, is putting upward pressure on global prices of these goods. During 2004-06, the
region accounted for about 40 percent of the global growth in demand for oil and more than 70
percent of the growth in demand for copper and zinc. The global commodities boom, which has
been stimulated by the emergence of the Chinese and Indian economies on the international scene,
has been an important offset to the deflationary effects from their low-priced goods and services.
Analysis by the Board's staff, which weights the negative effect on U.S. inflation from cheaper
manufactures against the positive effect from higher commodity prices, finds that the net effect in
recent years could go either way but in any case is probably quite small. Looking back before the
recent boom in commodities prices, the staff's best estimate is that China's and India's entrance on
the global trading scene has had a small negative effect on inflation. Research at the OECD (Pain,
Koske, and Sollie, 2006) reaches similar conclusions, finding a net effect of 0 to negative 1/4
percentage point for the United States, the euro area, and the OECD economies in aggregate.
Laurence Ball (2006) makes an important point that cheaper imports from places like China lower
relative prices for imported goods but ultimately do not affect inflation, which is the change in
overall prices. Following the argument made by Milton Friedman (Friedman, 1974), Ball points out
that for every decline in the relative price of one good or service in a price index like the consumer
price index (CPI), there is by definition a rise in the relative price of some other good or service.
Any pattern of relative-price changes is compatible with a particular level of the inflation rate.
What determines the overall inflation rate is not relative prices for one category of goods and

services but rather the balance between overall demand and supply in the economy, which
ultimately is influenced by monetary policy. Ball therefore takes the view that cheap imports from
China and other low-wage economies should not affect inflation.
I would not go as far as Ball does for the reason that changes in relative prices in an important
category of goods and services could affect inflation for a considerable period of time.
Nevertheless, his argument, as well as the research cited earlier, indicates that many of the
exaggerated claims that globalization has been an important factor in lowering inflation in recent
years just do not hold up.
Globalization and Output
The increasing integration of the global economy can have several effects on output. It is thus of
concern to monetary policy makers because it can affect both output volatility and our forecasts of
the economy.
Globalization may stabilize output by enabling producers to service a diversified global market
rather than just the domestic market. Research at the Federal Reserve Board (Ihrig and others,
2007) documents that net exports tend to be negatively correlated with domestic demand and thus
stabilize output; other research (Guerrieri, Gust, and López-Salido, 2007) finds that shocks to
domestic demand move output less in more open economies. In the opposite direction, greater trade
integration--including greater trade in services (Markusen, 2007)--could raise output volatility as
countries become more vulnerable to foreign shocks. There is indeed some evidence that this
situation has occurred in Mexico (Bergin, Feenstra, and Hanson, 2007).
As with the effects of greater trade integration on the volatility of output, the effects of financial
globalization can go both ways. Increasing global diversification lowers the likelihood that financial
shocks will be concentrated in individual economies and thus lead to economic downturns.
Furthermore, as I have emphasized in my writings (Mishkin, 2006a), financial globalization can
help promote institutional reforms that can make the financial system more stable, thereby
contributing to more output stability. However, as I have also emphasized in my work (Mishkin,
2006a, chap. 4), financial globalization makes it easier for capital inflows to fuel excessive risktaking on the part of financial institutions and allows financial shocks to be transmitted more readily
across borders.
On balance, my sense is that economic globalization has the potential to be stabilizing for individual
economies as both real and financial shocks are spread more evenly across larger numbers of
economic agents. One might even speculate that globalization has contributed to the so-called Great
Moderation, the decline in output variability in countries like the United States over the past twenty
years, and this hypothesis should be a topic for future research. The bottom line, however, is that it
is not at all clear whether globalization increases or reduces output volatility.
That said, as I have emphasized in my speeches and writings (Mishkin, 2006a, b; Mishkin, 2007b), I
strongly believe that globalization is and has been a key factor in promoting economic growth.
Globalization not only promotes a more competitive economic environment--which forces business
to innovate--but it also creates strong incentives for institutional reform to make markets work
better. Globalization in recent years has not only enabled hundreds of millions of people in
countries like China and India to escape abject poverty (income of less than $1 per day) but has also
helped economies like ours in the United States to be highly dynamic, which is essential to our
future economic well-being.
Globalization and the Monetary Transmission Mechanism
Four questions naturally arise when we consider whether globalization has changed the monetary
transmission mechanism, that is, how monetary policy influences inflation and output: (1) Has
globalization led to a decline in the sensitivity of inflation to domestic output gaps (the difference
between actual and potential output) and thus to domestic monetary policy? In other words, has
globalization made the Phillips curve flatter? (2) Are foreign output gaps playing a more prominent
role in the domestic inflation process, so that domestic monetary policy has more difficulty

stabilizing inflation? (3) Can domestic monetary policy still control domestic interest rates and so
stabilize both inflation and output? (4) Are there other ways, besides possible influences on
inflation and interest rates, in which globalization may have affected the transmission mechanism of
monetary policy?
Has globalization led to a decline in the sensitivity of inflation to domestic output gaps (the
difference between actual and potential output) and thus to domestic monetary policy?
In recent years, we have clearly witnessed a decline in the sensitivity of inflation to the domestic
output gap (a flattening of the Phillips curve) in the United States and other advanced countries
(Borio and Filardo, 2007; International Monetary Fund, 2006; Ihrig and others, 2007; Pain, Koske,
and Sollie, 2006). Globalization might make inflation less responsive to rising domestic resource
utilization because households and businesses can go outside the country to buy goods and services,
so there will be less pressure for domestic prices to rise. Another way of thinking about this point is
to recognize that globalization might reduce the likelihood of having supply bottlenecks as domestic
resource utilization rises. Although this story is a plausible one, research at the Federal Reserve
Board and elsewhere finds no evidence that the flattening of the Phillips curve reflects the process of
increasing trade integration (Ihrig and others, 2007; Ball, 2006; Wynne and Kersting, 2007).2
Rather than globalization being an important factor leading to flatter Phillips curves, I would argue
(as in Mishkin, 2007a) that flatter Phillips curves are the direct result of better monetary policy that
has anchored inflation expectations. Because monetary authorities are focusing more on
establishing a stronger nominal anchor, a rise in resource utilization will not lead to a rise in
expected inflation. Instead, households and businesses will expect monetary authorities to take the
necessary steps to ensure that the economy will not overheat, and, as a result, they will not push for
higher prices and wages. Not only is this explanation for decreased sensitivity of inflation to output
gaps more consistent with empirical evidence (see Mishkin, 2007a; Roberts, 2006), but it is more
consistent with the timing of when Phillips curves became flatter. In the United States, Phillips
curves started to flatten in the 1980s, well before the recent surge of globalization but just after
inflation expectations started to become anchored.
Are foreign output gaps playing a more prominent role in the domestic inflation process, so that
domestic monetary policy has more difficulty stabilizing inflation?
As economies have become more open, foreign factors may have become more important in the
determination of domestic inflation. Research at the Bank for International Settlements (Borio and
Filardo, 2007) seems to provide evidence that foreign resource slack has superseded domestic slack
as a key determinant of domestic inflation. However, research at the Federal Reserve Board (Ihrig
and others, 2007) and at the OECD (Pain, Koske, and Sollie, 2006) point out that the specification
of the Phillips curve in Borio and Filardo (2007) is problematic. Their key findings are not robust to
alternative specifications. Moreover, their specification leads to econometric difficulties because it
causes serial correlation of the residuals that is not corrected for.
Using more-conventional specifications of Phillips curves, the research at the Federal Reserve
Board (Ihrig and others, 2007) and the OECD (Pain, Koske, and Sollie, 2006), as well as Ball
(2006), finds that foreign output gaps are not important determinants of domestic inflation.
However, foreign factors could more plausibly play a role in the inflation process through import
prices. As economies become more open and imports play a bigger role in the economy, consumer
prices may become more sensitive to import prices. Indeed, CPI inflation does appear to have
become more sensitive to import prices over time, both in the United States and in other OECD
countries (Pain, Koske, and Sollie, 2006).3
Can domestic monetary policy still control domestic interest rates and so stabilize both inflation and
In principle, the increasing global integration of financial markets, by reducing the scope for
individual central banks to control domestic interest rates, could hamper the ability of monetary

policy to stabilize prices and economic activity. Indeed, some evidence appears to suggest that
foreign factors influence interest rates; for example, the global saving glut does seem to have led to
somewhat lower long-term interest rates by reducing term premiums (Warnock and Warnock,
2006). More generally, research points to important linkages between U.S. and foreign interest rates
and other asset prices (Ehrmann, Fratzscher and Rigobon, 2005; Faust and others, 2007). However,
central banks still retain the ability to control short-term interest rates, which affect the domestic
cost of credit and long-term interest rates, and so can continue to do their job of stabilizing inflation
and output.
Are there other ways, besides possible influences on inflation and interest rates, in which
globalization may have affected the transmission mechanism of monetary policy?
The preceding discussion might lead to the conclusion that globalization has not had important
effects, either on the behavior of inflation or the ability of monetary policy to affect the economy.
However, globalization might have an effect on the process of monetary transmission that does not
operate through Phillips-curve-type mechanisms.
One of the key transmission channels of monetary policy is the exchange rate. A tightening of
monetary policy, for example, raises U.S. interest rates relative to those abroad, thereby inducing
upward pressure on the foreign exchange value of the dollar. An appreciation of the dollar, in turn,
restrains exports (because the price of U.S. goods rises when measured in foreign currencies) and
stimulates imports (because imports become cheaper in dollar terms). The resulting decrease in net
exports implies a reduction in aggregate demand. In addition, an appreciation of the dollar that
leads to a decline in import prices also helps restrain overall U.S. inflation.
By expanding the share of tradable goods and services in the economy, globalization might increase
the role of the exchange rate as a transmission channel of monetary policy and could reduce the role
of the interest rate channel. The larger the share of imports and exports in the economy, the greater
the change in net exports--and, hence, in the contribution of net exports to gross domestic product
(GDP) growth--for a given change in the exchange rate. In addition, the larger the share of imports
in the economy, the larger should be the effect on overall CPI inflation of a given change in import
prices when the exchange rate changes.4 (This effect is explicitly incorporated in Federal Reserve
staff models of U.S. inflation, which weight import prices by the share of imports in the
consumption basket.)
By the same token, the effect of the interest rate channel on overall economic activity may be
diminished by greater trade integration as changes in domestic demand are offset by induced
changes in imports. Guerrieri, Gust, and López-Salido (2007), for example, find that shocks to
domestic demand move output less in more-open economies because they lead to larger offsetting
movements in the trade balance. Supporting this result, Ihrig and others (2007) conclude that
correlations between real GDP growth and real domestic demand growth have declined in recent
decades in the United States and several other industrial economies.
In addition to increasing the sensitivity of the economy to changes in exchange rates, globalization
may have increased the sensitivity of exchange rates to monetary policy. Over the past few decades,
as capital controls have been eliminated in most major economies and the levels of home bias in
portfolio investment have declined, financial markets around the world have become more tightly
integrated. An implication of this financial globalization is that demand for domestic and foreign
assets is likely to have become more sensitive to international differences in perceived rates of
return. Accordingly, monetary policy actions may now exert more influence on exchange rates than
was the case when markets were less tightly integrated and assets of different countries were
perceived to be less substitutable for each other. This linkage between globalization and the effect
of monetary policy on exchange rates is somewhat speculative but represents a worthwhile avenue
for further research.
Why Has Inflation Declined in Recent Years?
What does all the preceding analysis tell us about why we have had better inflation performance in

recent years? I don't know of anyone who would have predicted twenty years ago that inflation
would be so low and stable in so many countries. Has globalization been an important part of the
story of inflation's remarkable decline in recent years? In terms of direct effects, the discussion here
provides a clear-cut answer: No. Inflation has come down in the old-fashioned way. Tighter
monetary policy and a commitment to price stability by central banks throughout the world have led
to lower inflation and an anchoring of inflation expectations. These policies have had huge benefits-not only the achievement of low and stable inflation but also an improvement in the overall
performance of the economy.
Globalization, however, may have helped reduce inflation in more-subtle ways. By fostering
increased interactions among central banks, academics, and the public in many different countries,
globalization has helped spread a common culture that stresses the benefits of achieving price
stability. The resulting increased focus on price stability has been a key reason for the reduction of
inflation worldwide.
The increasing integration of global product, labor, and financial markets has the potential to
significantly alter the behavior of the economy, a development that could complicate the task of
monetary policy. In practice, however, the behavior of the U.S. and global economies does not
appear to have radically changed in recent years. The Federal Reserve and other central banks
retain the ability to stabilize prices and output. Nonetheless, central bankers must continue to
monitor the evolution of the economy and the changes that may result from the ongoing
globalization process.

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1. I want to thank Steven Kamin and Jaime Marquez for their helpful comments and assistance on
this speech. Return to text
2. International Monetary Fund (2006) does find some evidence supporting the hypothesis that
globalization flattens the Phillips curve: In a cross-country regression of inflation on, among other
factors, the trade share multiplied by the output gap, the interaction term is found to have a
significant negative coefficient. In the simpler specification of Ihrig and others (2007), however, the
effect of this interaction term is not significant. Return to text
3. International Monetary Fund (2006) finds indirect evidence supporting this channel--namely, that
inflation is affected by relative import prices multiplied by import shares in GDP and that import
shares have been rising over time. Ihrig and others (2007) document a rise in the sensitivity of U.S.
inflation to import prices over time, although they do not identify such a trend in other
countries. Return to text
4. A qualification of this point is that even as the share of imports in U.S. spending has risen, the
pass-through of exchange rates into import prices has declined. However, we do not know whether
the decline in pass-through is merely transitory or will be sustained. Return to text
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