The Global Slack Hypothesis

Federal Reserve Bank of Dallas Staff Papers No. 10, 2010

37 Pages Posted: 6 Jan 2011

See all articles by Mark A. Wynne

Mark A. Wynne

Federal Reserve Bank of Dallas

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Date Written: September 1, 2010

Abstract

We illustrate the analytical content of the global slack hypothesis in the context of a variant of the widely used New Open-Economy Macro model of Clarida, Galí, and Gertler (2002) under the assumptions of both producer currency pricing and local currency pricing. The model predicts that the Phillips curve for domestic CPI inflation will be flatter under most plausible parameterizations, the more important international trade is to the domestic economy. The model also predicts that foreign output gaps will matter for inflation dynamics, along with the domestic output gap. We also show that the terms of trade gap can capture foreign influences on domestic CPI inflation in an open economy as well. When the Phillips curve includes the terms of trade gap rather than the foreign output gap, the response of domestic inflation to the domestic output gap is the same as in the closed-economy case ceteris paribus. We also note the conceptual and statistical difficulties of measuring the output gaps and suggest that measurement error bias can be a serious concern in the estimation of the open-economy Phillips curve relationship with reduced-form regressions when global slack is not actually observed.

Keywords: Global slack hypothesis, Phillips Curve, inflation, globalization

JEL Classification: E3, F4

Suggested Citation

Wynne, Mark A. and Martinez-Garcia, Enrique, The Global Slack Hypothesis (September 1, 2010). Federal Reserve Bank of Dallas Staff Papers No. 10, 2010, Available at SSRN: https://ssrn.com/abstract=1734930

Mark A. Wynne (Contact Author)

Federal Reserve Bank of Dallas ( email )

PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5159 (Phone)
214-922-5194 (Fax)

Enrique Martinez-Garcia

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

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