The Role of Global and Domestic Shocks for Inflation Dynamics: Evidence from Asia*
| Published date | 01 October 2022 |
| Author | David Finck,Peter Tillmann |
| Date | 01 October 2022 |
| DOI | http://doi.org/10.1111/obes.12495 |
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 84, 5 (2022) 0305-9049
doi: 10.1111/obes.12495
The Role of Global and Domestic Shocks for Inflation
Dynamics: Evidence from Asia*
DAVID FINCK and PETER TILLMANN
Justus-Liebig-University Gießen, Gießen, Germany (e-mail:
david.finck@wirtschaft.uni-giessen.de)
Abstract
This article studies inflation dynamics and the output– inflation trade-off in small open
economies. We estimate a series of VAR models for a set of six Asian emerging
market economies, in which we identify a battery of domestic and global shocks using
sign restrictions. We find that global shocks explain large parts of inflation and output
dynamics. A series of counterfactuals support these findings and suggest that the role of
monetary policy is limited. We estimate reduced-form Phillips curve regressions based
on alternative decompositions of output into global and domestic components. For most
countries, we find a positive and significant correlation between inflation and the fraction
of GDP driven by domestic shocks only. While including the output component driven
by oil prices seems to ‘flatten’ the Phillips curve, though the effect is not significant, the
component driven by global demand shocks ‘steepens’ the inflation– output nexus.
I. Introduction
Over the past two decades, many advanced and emerging economies experienced low and
relatively stable inflation rates. At the same time, inflation more and more appeared to be
decoupled from economic activity. The sharp drop in GDP during the Great Recession
did not lead to a further drop in inflation, thus giving rise to the ‘missing deflation’
phenomenon. Likewise, the strong economic recovery did not go hand in hand with rising
inflation rates. Based on these observations, a large literature studies the changing nature
of inflation dynamics and, in particular, the shifting relationship between inflation and
economic activity. This research agenda is often described in terms of a ‘flattening’ of
the Phillips curve (see Coibion and Gorodnichenko, 2015, and others). A reduction in the
slope of the Phillips curve relationship would have consequences for monetary policy.
For given inflation expectations, the argument goes, a flatter Phillips curve would require
a deeper recession in order to bring high inflation back to the target.
JEL Classification numbers: E3, E5, F4.
*This project has been conducted while we were Visiting Research Economists at the SEACEN Centre. We thank
the SEACEN Centre for its hospitality. Seminar participants at the Reserve Bank of Australia, Giessen and the
SEACEN Centre provided very helpful comments. We are particularly grateful to comments from the editor of
this journal and three anonymous reviewers. We also thank Peter Winker, Daniel Grabowski and J¨
org Schmidt
for comments and suggestions.
1181
©2022 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and
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1182 Bulletin
One explanation for the apparent changes in the inflation process is the ongoing global
integration of financial and goods markets. However, quantifying the extent to which
global forces explain inflation is not straightforward. In her survey article, Forbes (2019)
argues that the role of global factors (commodity prices, measures of global slack,
exchange rates, price competition) has changed over time. She finds that the relation
between domestic output gaps and inflation rates has weakened and advocates that models
of inflation such as the Phillips curve should incorporate changes in the global economy
in order to provide a good account of the determinants of inflation. If global factors are
indeed driving a substantive share of inflation, domestic monetary policy is less able to
stabilize inflation and the real economy. As monetary policy primarily affects inflation
through expanding or contracting domestic demand, the power of central banks to control
inflation would be limited in a world in which global forces dominate.
In this article, we add to this literature and study six Asian emerging market countries:
Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand. These countries are
prototypical small open economies that are well integrated into the world economy.1In
addition, all six economies explicitly or implicitly have a monetary policy mandate for
maintaining price stability.2Recently, IMF (2018) claims that the sensitivity of inflation
rates in Asian emerging market economies with respect to real activity declined, thus
leading to a flatter Phillips curve.
We shed new light on the determinants of inflation by disentangling domestic and
global driving forces based on a series of counterfactuals. For example, we split GDP
growth into the component that reflects domestic shocks and the part that is driven by
global demand shocks. These decompositions show that GDP driven by domestic shocks
elicits a Phillips curve relationship that differs from the relationship between inflation and
the part of GDP driven by global shock.
We proceed in three steps. First, we estimate a series of structural vector autoregressive
(VAR) models, in which we use alternative sets of constraints to identify a battery of
shocks. In our baseline model, we apply sign restrictions as in Corsetti et al. (2014)
to identify domestic demand and supply shocks as well as global demand and supply
shocks. While demand and supply shocks can be distinguished based on the responses
of inflation and GDP growth being positively correlated (in the case of demand shocks)
or negatively correlated (for supply shocks), we disentangle domestic from global shocks
based on the relative response of domestic GDP to world GDP. Second, the identified
VAR model allows to apply several structural analyses in order to address the role of
the structural shocks on inflation and on the growth rate of real GDP. In doing so, we
focus on four categories of shocks, i.e. global, domestic, monetary policy and residual
shocks. We first decompose the variance of forecast errors. The forecast error variance
decomposition (FEVD) tells us how much of the forecast error variance can be explained
by exogenous shocks to other variables in the system. While the FEVD describes average
movements in the data, it does not allow us to quantify the amount of how much of
the observed variability is explained by specific shocks. Hence, we also decompose the
1Auer and Mehrotra (2014) argue that the integration of Asian economies into global supply chains matters. The
correlation of inflation rates across Asian economies increases with the extent of their bilateral trade relationships.
2SeeVolz(2015) for a discussion of the experience with inflation targeting in Asia.
©2022 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
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