How Does Global Disinflation Drag Inflation in Small Open Economies?
Central Bank of Peru
University of Cambridge - Faculty of Economics and Politics; Central Reserve Bank of Peru
November 8, 2004
This paper shows the way how persistent world inflation shocks hitting a small open economy can re-weight the importance of domestic and foreign factors in the determination of prices. In this sense, we study why the recently observed global disinflation environment may imply a weakening of the standard interest rate channel of monetary policy to affect inflation. We derive a state-dependent Phillips curve based on translog preferences that make the elasticity of substitution of domestic goods sensitive to foreign prices. With this approach we are able to replicate the dragging effect of global disinflation on domestic inflation, as experienced in small open economies such as New Zealand, Chile and Peru.
Number of Pages in PDF File: 34
Keywords: Monetary policy, Phillips curve, translog preferences
JEL Classification: E31, E52
Date posted: April 19, 2004