Globalization Has Weakened The Ability Of Central Banks To Control The Dynamics Of Inflation

This essay will look at the role increasing globalisation has had on a central banks ability to control the dynamics of inflation. The main literature on this topic is by Woodford (2007) and many agree with his views on globalisation and, as typical in economics, many disagree. This essay will look at different avenues of thought on the subject giving arguments for and against for both sides. It will look at the new consensus model and the increase in international integration of three key areas financial integration, goods market integration and factor market integration. As inflation is one of the trade-off factors in the Phillips curve it will also be looking at what effect globalisation has had on the Phillips curve and the view that globalisation has flattened the Phillips Curve and if so what problems will the central banks face from this. The new consensus model consists of 4 key aspects output gap, Phillips curve, exchange rate movement and central banks policy rates and with ever-increasing globalisation the coefficients which make up these aspects can have a serious consequence on a central banks ability to control the dynamics of inflation.

International financial integration must be considered for a monetary transmission mechanism and many economists have studied this topic in great detail and are divided on the subject. Kose (2006) believed that within the last part of the century, the amount of cross country finance has increased and the correlation between these different countries real interest rates is stronger. What he means by this is that due to the increasing globalisation and cross country financial integration, interest rates in each country will be more inclined to be determined by the current world conditions instead of the host country, thus domestic monetary policy is redundant in controlling domestic interest rates. Rogoff (2006) agreed with this view as he believed individual central bank s monetary policy matters less in a globalised world but it does not imply central banks have less influence over real interest rates collectively (pp 273) by this he is suggesting that although central bank s monetary policies will not be significantly effective on its own country, it will have a say in world real interest rates when collected with many other countries and their policies. Woodford (2007) created a two-country new-Keynesian model to see if the globalisation of finance did affect the significance of a countries monetary policy. Woodford s model (2007) showed that even in a small economy country, where one may believe globalisation would have a big impact on them, monetary policy does not cease to be effective for domestic inflation targeting as a result of globalisation. These findings also show that monetary policies in foreign countries do not affect inflation determinants in the home country. However, within Woodford s (2007) models, they are only tested against two countries but in a global economy there are a more than just two countries present, so these results lose some credibility as they cannot fully explain or prove globalisation effects when only based on two countries.

Additionally, the increased integration of financial markets has allowed for buyers all over the world to choose between assets in one country and another, all with their own degree of risk. Also the financial integration has allowed for companies and financial institutes to borrow from all over the world. This can present a big risk to a central bank and a good example of this is the financial crisis which occurred in 2008, because of the global integration the collapse of the US banks affected the whole world, and Northern Rock which, due to the collapse in the USA, had to file for liquidation and the central bank had to bail them out. With this in mind, during a countries economic boom and bust financial stability must be more important for a central bank than inflation targeting and therefore the strength of a central bank in controlling inflation is weakened.

Within the financial integration umbrella, some economists believe, exchange rates are more significant due to globalisation, as a countries domestic monetary policy on exchange rates will have big implications on their own inflation. Woodford (2007) argues that by adding a log-linear approximation to his two-country model the results show that even the central bank of a very small country must be able to substantially affect domestic inflation by changing its policy for it can change the inflation differential, and (at least in the case of a very small country) this must not be because it changes the inflation rate in the rest of world but not at home. (pp 17) What Woodford (2007) is trying to point at is the results imply that a countries central bank must, but not only, be able to shift the AD curve, but they must be able to get a grip on the interest rate, regardless of the nature of aggregate supply in the world. Svensson (2000) agreed with this and argues that achievement of a central bank`s inflation target is possible over the short-run in the case that the economy is open (globalised) assuming there is no lag in the changes of exchange rates to the imported goods prices. Fisher (2005) and the economist (2005) both disagree with Woodford (2007) and suggest the old models of inflation do not take globalisation into account. In conclusion of this area of globalisation most economists feel financial globalisation does not have a significant effect on a central bank s monetary policy, nor does a foreign country s own monetary policies. However research does suggest that exchange rates must depreciate as a result either of an increase in the relative tightness of foreign monetary policy or of an increase in relative foreign output to be able to have a positive effect on inflation. I also believe that exchange rates are very important for price pressures from abroad and the central bank needs to be more worried over these than Woodford (2007) suggests.

Increased aggregate demand has inflationary pressures on a country so the central bank must try to control the domestic countries aggregate demand, however with globalisation central banks are losing the monopolists in financial claims in the country. Matthew Davis (2012) puts it as a situation in which there is an overabundance of money in search of investments __ will be determined solely by global, not national, forces. (nber.org 2012) Global liquidity is now deemed to be the determinant of the degree of stimulus to aggregate demand in the country and abroad and many financial institutes believe the increased global liquidity as a factor that has caused an asset price boom. With this understanding, in an ever increasing globalised world economy, people believe that this influx of global liquidity should cause problems for a central bank to control their inflation rates and with regards to small countries this should cause significantly more problems to them due to their small input in world liquidity. The European Central Bank (2005) states we conclude that excess liquidity is a useful indicator of inflationary pressure at a global level and therefore merits some attention in the same way as the level of interest rates, if not possibly more (pp 2) showing that they believe that global liquidity could be significant in inflationary pressure and thus central banks must look toward this when dealing with their monetary policies. Woodford (2007) however argues that the price level in a given country depends only on current and expected future monetary policy in that country alone, and not on global liquidity (pp 32) suggesting that global liquidity play little part in the price levels in a country and a central bank biggest issue would be to offset the inflationary impact of variations of global liquidity. The flattening of the Phillip's curve has been seen in recent years and when looking at literature on globalisation the flattening of the Phillip s curve is always present. Many economists, most notably Rogoff (2006), Boeckx (2006) and Borio Filardo (2007) believe globalisation has caused this flattening. Their main argument on the matter is that domestic firm s prices are set by world supply and demand and the foreign competitiveness is changing the domestic firms abilities to price set in their own domestic market and thus during a boom domestic firms cannot raise prices which in a closed economy or a less global economy they could. On the other side of the Phillips Curve, the unemployment side, they believe that wages have to stay low because of the competiveness of cheap labour abroad, so if the wage increases firms would move to cheap labour areas to keep maximising profit and this would cause the unemployment trade-off to be less significant. I believe that the flattening of the Phillips curve will cause central banks to be less inclined to control inflation as it would be less sensitive to change due to the reduction in the trade-off between inflation and unemployment.

Gaiotti (2010) conducted research into this area and found his results found no support for the argument that globalisation has caused the Phillips curve to flatten. Ball (2007) and Ihrig (2007) found that globalisation had little effect on the sensitivity of inflation and therefore should not affect a central bank when conducting monetary policy. Although these economists disagree entirely with the above view, some economists most notably Iakova (2007) and Yellen (2006) believe the flattening should be partly attributed to globalisation, in Iakova s paper she suggests that good monetary policy has been able to control the expectations of inflation and Yellen (2006) states that globalisation may not effect a central banks ability to control inflation but just causes difficulties in the central bank s objectives of policies. Mishkin (2007) actually believes a flattening of the Phillips Curve is a signal of a better monetary policy set out by central banks and there is no argument for the increase in globalisation to suggest the flattening is due to this. The research into the arguments for and against globalisation and its effects on the Phillips Curve have some problems, these problems being the fact that most research is only through a two country model and not for the whole economy.

In conclusion, I believe that the central bank s ability to control inflation has been effected by globalisation. I feel the speed and ease that the movement of money can move through countries plus the ability of consumers to buy from any country will, and does, cause problems for central banks. Although there is a lot of literature on this topic, not one paper clearly defines exactly the results of globalisation and I feel more detailed research and comparisons between a large economy and small economy is needed. The literature also comes up inconclusive with Woodford (2007) arguing globalisation has no effect and Yellen (2006) suggesting it causes problems for central banks. Gaiotti (2010) even states that the empirical data results on the topic come up inconclusive with some agreeing and some disagreeing. The title itself states: globalization has weakened the ability of central banks to control the dynamics of inflation, and I feel this is too broad a statement plus too general and as this essay proves, the answer is not a simple yes no.