Mind the Gap!—A Monetarist View of the Open-Economy Phillips Curve
Globalization Institute Working Paper Series No. 392
40 Pages Posted: 29 Jul 2020 Last revised: 3 Sep 2020
Date Written: June 15, 2020
In many countries, inflation has become less responsive to domestic factors and more responsive to global factors over the past decades. We introduce money and credit into the workhorse open-economy New Keynesian model. With this framework, we show that: (i) an efficient forecast of domestic inflation is based solely on domestic and foreign slack, and (ii) global liquidity (global money as well as global credit) is tied to global slack in equilibrium. Then, motivated by the theory, we evaluate empirically the performance of open-economy Phillips-curve-based forecasts constructed using global liquidity measures (such as G7 credit growth and G7 money supply growth) instead of global slack as predictive regressors. Using 50 years of quarterly U.S. data, we document that these global liquidity variables perform significantly better than their domestic counterparts and outperform in practice the poorly-measured indicators of global slack that global liquidity proxies for.
Keywords: Global Slack, Global Liquidity, New Open-Economy Phillips Curve, Open- Economy New Keynesian Model, Forecasting
JEL Classification: F41, F44, F47, C53, F62
Suggested Citation: Suggested Citation