The effect of trade and financial liberalization on flationary volatility

UNIVERSITY OF ECONOMICS HO CHI MINH CITY ------ LÊ THỤY PHƯƠNG TÂM THE EFFECT OF TRADE AND FINANCIAL LIBERALIZATION ON INFLATION VOLATILITY Master thesis in Economic HO CHI MINH

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

- -

LÊ THỤY PHƯƠNG TÂM

THE EFFECT OF TRADE AND FINANCIAL LIBERALIZATION ON

INFLATION VOLATILITY

Master thesis in Economic

HO CHI MINH - 2017

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

- -

LÊ THỤY PHƯƠNG TÂM

THE EFFECT OF TRADE AND

research and that I have acknowledged all material and sources used in its preparation, whether they be books, articles, reports, and any other kind of document I also certify that this thesis has not previously been submitted for assessment in any form to the University of Economics Ho Chi Minh City or to any other institution for any other purposes

Ho Chi Minh, 12 October 2017

DECLARATION OF ORIGINALITY

LIST OF ABBREVIATIONS

LIST OF TABLES

LIST OF FIGURES

ABSTRACT

CHAPTER 1 INTRODUCTION AND RESEARCH QUESTION 1

1.1 INTRODUCTION 1

1.2 RESEARCH QUESTIONS 7

CHAPTER 2 LITERATURE REVIEW 8

2.1 THEORETICAL LITERATURE 8

2.1.1 Trade Liberalization 8

2.1.2 Financial Liberalization 10

2.1.3 Inflation 12

2.1.4 Inflation and Inflation Volatility 14

2.1.5 Trade Liberalization and Inflation Volatility 16

2.1.6 Financial Liberalization and Inflation Volatility 18

2.2 EMPIRICAL EVIDENCE 20

2.2.1 Inflation and Inflation Volatility 20

2.2.2 Trade Liberalization and Inflation 21

2.2.3 Trade Liberalization and Inflation Volatility 23

2.2.4 Financial Liberalization and Inflation 25

2.2.5 Trade and Financial Liberalization simultaneously and Inflation 26

CHAPTER 3 DATA AND METHODOLOGY 28

3.1 DATA 28

CHAPTER 4 EMPIRICAL RESULTS 39

4.1 LIBERALIZATION AND INFLATION VOLATILITY 39

4.2 ROBUSTNESS ANALYSIS 43

4.2.1 Effect of trade and Financial Liberalization joinly 43

4.2.2 Adding further controls 44

4.2.3 Varying the data frequency 47

4.2.4 Varying the Inflation Volatility using annual data 50

4.2.5 Varying the measurement for Financial Liberalization 51

CHAPTER 5 IN REFERENCE TO VIETNAM 52

CHAPTER 6 CONCLUSIONS 55 REFERENCES

APPENDIX

FEM: Fixed effect model

FO: Financial openness

GDP: Gross Domestic Product

GMM: Generalized method of moments GNP: Gross National Product

GEXP: Government expenditure growth GROWTH: GDP per capita growth IFS: International Financial Statistic IMF: International Monetary Fund INF: Inflation

OLS: ordinary least squares

POP: Population

REM: Random effect model

RGDP: GDP per capita

TO: Trade openness

VINF: Inflation volatility

VOL: GDP per capita volatility

WDI: World Development Indicator WEO: World Economic Outlook

WTO: World Trade Organization

TABLE 3.2 DESCRIPTIVE STATISTICS FOR MAIN VARIABLES 33

TABLE 3.3 DESCRIPTIVE STATISTICS FOR CONTROL VARIABLES USED IN ROBUSTNESS SECTION 33

TABLE 3.4 CORRELATION MATRIX FOR MAIN AND CONTROL VARIABLES 34

TABLE 4.1 REGRESSION RESULTS: TRADE OPENNESS AND INFLATION VOLATILITY 39

TABLE 4.2 REGRESSION RESULTS: FINANCIAL OPENNESS AND INFLATION VOLATILITY 41

TABLE 4.3 REGRESSION RESULTS: THE EFFECT OF TRADE OPENNESS AND FINANCIAL OPENNESS SIMULTANEOUSLY 42

TABLE 4.4 ROBUSTNESS ANALYSIS: EFFECT OF TRADE AND FINANCIAL OPENNESS JOINTLY 43

TABLE 4.5 ADDITIONAL CONTROLS: TRADE OPENNESS AND INFLATION VOLATILITY 45

TABLE 4.6 ADDITIONAL CONTROLS: FINANCIAL OPENNESS AND INFLATION VOLATILITY 46

TABLE 4.7 DIFFERENT DATA FREQUENCY: SIX-YEAR WINDOWS 48

TABLE 4.8 DIFFERENT DATA FREQUENCY: SIX-YEAR ROLLING WINDOWS 49

TABLE 4.9 INFLATION VOLATILITY USING ANNUAL CPI DATA 50

TABLE 4.10 DE JURE MEASUREMENTS FOR FINANCIAL OPENNESS 51

TABLE 5.1 REGRESSION RESULTS FOR VIETNAM 54

TABLE 0.1 HAUSMAN TEST FOR THE FIRST MODEL WITH TRADE OPENNESS

TABLE 0.2 HAUSMAN TEST FOR THE SECOND MODEL WITH FINANCIAL OPENNESS

TABLE 0.3 CORRELATION MATRIX OF VARIABLES IN THE FIRST MODEL

TABLE 0.4 CORRELATION MATRIX OF VARIABLES IN THE SECOND MODEL

TABLE 0.5 MODIFIED WALD TEST FOR TRADE OPENNESS

TABLE 0.6 MODIFIED WALD TEST FOR FINANCIAL OPENNESS

OPENNESS

TABLE 0.9 UNIT-ROOT TEST FOR VINF

TABLE 0.10 UNIT-ROOT TEST FOR TO

TABLE 0.11 UNIT-ROOT TEST FOR FO

TABLE 0.12 UNIT-ROOT TEST FOR RGDP

TABLE 0.13 UNIT-ROOT TEST FOR GEXP

TABLE 0.14 UNIT-ROOT TEST FOR VINFT1

3 FIGURE 3.1 SCATTER PLOTS BETWEEN TRADE OPENNESS AND INFLATION

VOLATILITY 35 FIGURE 3.2 SCATTER PLOTS BETWEEN FINANCIAL OPENNESS AND INFLATION

VOLATILITY 35 FIGURE 5.1 INFLATION, TRADE AND FINANCIAL OPENNESS IN VIETNAM 53

inflation volatility, and between financial liberalization and inflation volatility Using a set of dynamic panel data for 142 emerging market and developing countries over the period of 1991-2014, this research finds statistically significant associations between each openness variables and inflation volatility The robustness analyses also consider other control variables, different time windows and different measurements for inflation volatility as well as financial liberalization The same result is consistently observed for both trade and financial openness, suggesting that trade and financial liberalization are associated with lower inflation volatility

CHAPTER 1 Introduction and Research Question

1.1 Introduction

Inflation and its volatility are some of the most important figures which have received lots of attention from economic experts as they affect economic stability and development Economists and monetary policy practitioners generally recognize that low levels of inflation and its volatility would render efficient and grown economy Bruno and Easterly (1998) suggests that high inflation is harmful

to the economy In addition, many previous studies reveal the adverse effects of high inflation such as declines in real wage, discouragement to investment, decreases in competitiveness, and reduction in the value of savings in the economy While the belief that inflation is detrimental to the economy is strong, the topic of inflation volatility has also received great interests from scholars Elder (2004) and Fatás and Mihov (2005) suggest that high volatile rate of inflation can weaken economic growth throughout their studies In fact, some other studies have suggested certain disturbing effects inflation volatility may impose on an economy (Golob, 1994 and Friedman, 1977) which will be discussed in more detail in the later sections Because the impacts inflation and inflation uncertainty put on real things (e.g employments investments and returns), controlling for both inflation and its uncertainty is critical to macroeconomic policies

In the past decades, the world has experienced two distinctive economic trends

First, on average, many countries have seen signs of disinflation over the years Second, countries have liberalized their trade policies so that they are engaged in

more trades across the globe Beside the rises in liberalization of trade, increases in international capital flows have also been observed recently (Ball, 2006) Lane and Milesi-Ferretti (2006) observe a rapid expansion of both foreign portfolio investment (FPI) and foreign direct investment (FDI) since the 1990s

Data taken from the World Economic Outlook (WEO) database is used to illustrate the mentioned trends Figure 1.1 represents the percentage change in inflation while

figure 1.2 shows volume of exports and imports as well as net financial transactions As can be seen from figure 1.1, inflation for the world on average shows a downward trend A trend line, drawn for inflation in emerging market and developing countries, also show a strong decreasing trend Figure 1.2 illustrates considerable increasing trends in exports, imports and financial transactions for emerging market and developing countries Volume of trade and net financial transactions are calculated in U.S dollars Even though the graph shows various fluctuations, the trend lines do show increases in trades and financial transactions

Figure 1.1 Inflation from 1991 to 2014

Fig 1.1 Scatter plots with smoothing lines for the percentage change in inflation based on average consumer prices for emerging market and developing countries, advanced economies and the World from 1991 to 2014 The linear trend line is also shown for emerging market and developing economies Data source: The World Economic Outlook database, April 2017 edition

Figure 1.2 Exports, Imports and Financial transactions from 1991 to 2014

Fig 1.2 Scatter plots for the volume of total export and import and net financial transactions for emerging market and developing countries from 1991 to 2014 Data is in billions of U.S dollars Data source: The World Economic Outlook database, April 2017 edition

Despite the existence of this recent phenomenon, empirical studies in the past have mostly focused on the effect of trade liberalization, but not on financial liberalization In this thesis, the main objective is to examine the relationship between economic liberalization and inflation volatility aiming to confirm if the three mentioned trends are indeed related Particularly, it is of interest to investigate the influences of trade and financial liberalization on inflation volatility for emerging market and developing countries

There exist several studies that relate inflation to other variables such as political instability (Aisen and Veiga, 2007), central bank independence (Cukierman et al,

1992), exchange rate regimes (Bleaney and Fielding, 2002) and fiscal policies (Rother, 2004) The relation between economic openness and inflation remains one

of the most widely researched topics Many researchers find that trade openness leads to lower inflation figures when it is expanded (Romer, 1993 and Lane, 1997) Romer finds that in a more open economy, government generates more revenue from a given tariff so that governments become less dependent on other sources of revenue such as seignorage As a result, the costs of inflation would be larger in more open economies, thus reduce inflationary shocks generated by policy makers Empirically, previous finding with regards to this relationship is contrasting While Romer (1993), Lane (1997), Gruben and McLeod (2004) support negative links, Narayan, Narayan and Mishra (2011) propose a positive effect Alfaro (2005) and Shambaugh and Klein (2010) did not find any statistically significant effect of trade liberalization on inflation

In regards to financial openness (capital flow openness), financial openness brings possibilities for risk reduction by diversifying portfolio and consumption smoothing Besides, it may have an effect on policy makers’ decisions to undertake better monetary policies As pointed out by Bartolini and Drazen (1997), they suppose that capital flow openness provides more access to foreign capital, increases the elasticity of demand for money, reduces the incentive to print money excessively and decreases inflation rate In the beginning of 1990s, there was a general belief that relaxation of capital controls brings benefits similar to relaxation

of trade barriers (Gupta, 2008) After the financial crisis, the relationship between financial openness and inflation became questionable since worst affected countries were the ones that adopt financial liberalization Empirical studies have also showed ambiguous findings In particular, Gruben and McLeod (2002) and Tytell and Wei (2004) present that capital account openness tends to reduce inflation Rodrik (1998) concludes that there is no proof of association McKinnon and Mathieson (1981), in contrast, suggested that the imposition of capital controls reduces inflation

On the one hand, the relation between openness and inflation volatility has been

studied by some economists, nevertheless the number of the studies is not abundant Most of their studies focus on the relation between trade openness and inflation volatility (Granato, 2006 and Bowdler and Malik, 2015) Bowdler and Malik (2015) find an evidence for a negative impact of trade openness on volatility of inflation

On the other hand, it is difficult to find a study about the effect of financial openness on inflation volatility To the best of my knowledge, there have been very few studies which examine the effect of both trade and financial liberalization on inflation Ghosh (2014) used both de jure and de facto measurements to show how inflation is influenced by openness and exchange rate regimes Badinger (2008) provides evidence on the link between inflation and globalization, referred to as trade and financial liberalization

This thesis aims to close the literature gap by conducting a research about the effect

of both trade and financial liberalization on inflation volatility This will give information on the ultimate relationship between openness and inflation volatility

In this thesis, a dynamic panel model using a dataset spanning 142 countries, which are emerging market and developing countries, in the world from 1991 to 2014 is used

The results indicate that liberalization of trade and financial are associated with lower inflation volatility The effect of liberalized trade is consistent with evidence presented by Bowdler and Malik (2015) With regards to financial openness, it is also aligned with previous studies (Gruben and McLeod, 2002 and Tytell and Wei, 2004), which indicate negative effect of financial liberalization on inflation

The remainder of this thesis is organized as follows Section 2 discusses both theoretical and empirical evidences, which include definitions and the channels through which economic openness effect inflation and inflation uncertainty Empirical literature provides summary and brief discussions on relevant researches relating to this topic Section 3 describes the dataset in details, including descriptive

statistics, the econometric models and statistical approaches Section 4 outlines empirical results for both trade and financial openness, and robustness tests for a set

of other control variables, different data frequency and measurements Section 5 refers to the current economic trends any basic relevance relating to Vietnam exclusively Finally, section 6 concludes on the evidence and informative reference for policy makers

1.2 Research Questions

As stated previously, the main objectives rest on the links between trade liberalization and inflation volatility, and between financial (capital account) liberalization and inflation volatility The specific research question specifies as follows

- Is there any (statistically significant) association between openness (i.e trade and financial) and inflation volatility?

CHAPTER 2 Literature Review

or agreements The adoption of free trade can occur on a unilateral or bilateral basis between countries Members of this group of countries negotiate and agree on a set

of relaxed trade restrictions or even complete removal of trade barriers between them They, however, manage their own trade policies with other non-members

2.1.1.2 Advantages

Trade openness brings many benefits to all trading partners as follows First,

diversifying trade means that domestic country can trade with international markets, and have access to high quality and less expensive products This supports for a more efficient economy, increased productivity and an improvement of living standard Consumers ultimately benefit from free trade as they now have access to a range of products with lower prices and more diversified in term of quality and

options available Second, trade offers specialization based on comparative

advantage, which means producers can reach their optimal welfare when they concentrate in the production of the products that can be produced at a lower opportunity cost Countries enjoy the economic benefits from capturing the area of comparative advantage and allocating factors of productions, i.e land, labor, capital

and entrepreneurship, effectively Third, there has been considerable debates among

experts that trade liberalization brings opportunities for job creation They suppose that exporting sectors increase employment due to the increase in supply of products in these sectors, but decreased employment occurs in importing sectors

because of increased competitions In general, trade liberalization motivates the

increase in consumer’s purchasing power, which leads to more job growth Fourth,

liberalized trade aids to limit monopolistic behavior in the economy Because the participation of international firms creates competition, local firms adapt to this new environment by modifying their operation such as decreases in price charging in the

market Fifth, trade liberalization fosters the competition of local firms due to

existence of overseas markets With appropriate enhancing national policies to manage trade, liberalization encourages competition and investments This promotes local firms to produce more effectively with lower costs, technology

innovation and efficient resources Finally, as mentioned previously, liberalization

of trade boosts economic growth as firms engage in more competition and improved productivity Economic development enhances living standard and real wages Overall, liberalized trade is recommended to be engage on a multilateral basis so that many nations can enjoy the benefits it provides

All in all, some of the advantages from trade liberalization relate to inflation Specifically, trade openness brings diversified basket of products and the more choices for consumers In addition, trade liberalization makes the market more competitive, hence it limits the increase in prices and contributes to disinflation Moreover, it makes policy makers more considerate with the shocks to inflation These create more motivation to research on the relationship between trade openness and inflation volatility

2.1.1.3 Disadvantages

Aside from the advantages liberalized trade bring, it has also received several criticisms However, its drawbacks are not stem from the principle of trade liberalization, but the failure of implementation The following briefly discuss some

of its disadvantages Firstly, imbalance in bilateral trade is caused by the

disproportion in supply and demand between corresponding countries In the long run, it is difficult to become a prosperous economy through participation in trade

with international markets, if it is a poor and less diversified economy Next, the

complex rules and contracts among participants might raise higher costs in international trade as partners monitor and ensure that agreed terms are followed

Besides, the more dependence on international markets a nation becomes the more

exposure to an unstable economy it suffers Businesses and consumers are subject

to more risks in the event of negative shocks experiencing by their trading partners

Additionally, infant firms may find it difficult to grow and participate in such

competitive markets without any protection policy from the government When trade openness occurs in these economies, the well-established or dominant firms

can swallow them easily Finally, dumping is often known as an issue that goes

beyond the control of firms in the trading environment Firms with excessive inventories may market their products at a price lower than costs Sectors operating

at full equilibrium may then find it extremely challenging to compete Given such conditions, market participations may employ unethical practices to improve their market position These behaviors may include improper use of intellectual property, mimic well-known trademarks and misrepresentation

2.1.2 Financial Liberalization

2.1.2.1 Summary

Financial openness is defined as the financial system of domestic country unites with that of the rest of other countries in the world The country, which integrates with international financial markets, is obligated to relax their rules and regulations Integration holds when an open economy goes through a rise in cross – country capital movement which involves not only the interaction between both debtors and creditors in local country and the international markets, but also the participation of international financial intermediaries

2.1.2.2 Advantages

Financial openness brings many benefits to all participants, especially ones in developing and emerging countries Particularly, financial liberalization help countries’ financial system become more stable and better regulated Basically,

financial liberalization motivates the financial system in two ways First of all, there

are more available funds through financial liberalization This is because funds can flow liberally from countries with excess capital to countries with scarce capital for production or investment Beside the funds that are available domestically, borrowers now have access to capital from foreign investors who believe in the potential growth of the domestic market Furthermore, the local debtors are imposed with market discipline by foreign investors as they usually have more restrictions

when invest internationally Second of all, the financial infrastructure is

strengthened and this leads to a decrease in the issue of asymmetric information This brings more transparency and efficiency in the financial infrastructure Additionally, when asymmetric information exists, the market does not operate as efficiently Financial liberalization then also improves the problem of adverse selection and moral hazard in a way that asymmetric information is minimized Besides, when foreign bank enters local country, it improves the financial infrastructure in other dimensions (Mishkin, 2003) First, foreign banks are less sensitive to negative shocks that impact home country, as they are able to diversify risks by having access to different sources of funds from around the world Second, when banks have issue with solvency, governments will not be willing to bail out due to the existence of dominated foreign banks Hence, this promotes not only a more prudent behavior by banking institutions, but also a decrease in moral hazard

In general, financial openness is one of the factors affecting inflation and inflation volatility through its advantages As mentioned previously, when more investments and funds flow into a country, government tends to limit printing money and considers any decision thoughtfully to avoid any adverse effects on funds from

abroad These lead to a decrease in inflation of the country, thus this study has more evidences to execute estimate regarding the effect of financial liberalization on inflation volatility

2.1.2.3 Disadvantages

Despite the fact that financial openness brings tremendous benefits, it has been

found to be associated with crises First, as foreign and domestic investors reinforce

market discipline, deterioration of market fundamentals can lead to a crisis Specifically, investors usually overreact with both bad and good news, so minor changes in fundamental might change investors’ perception of risk dramatically

Second, the crisis can be caused by the international financial markets’

imperfection, which creates bubbles and speculation Third, contagion is a factor

that relates to financial crises in the world This presents through two dimensions including real links and herding behavior Regarding first dimension, real links are associated with trade in a way that trading partners are influenced by external factors such as exchange rate A change in exchange rate in one country will eventually transmit across countries Next, I move on to herding behavior, which pertains to asymmetric information Due to the cost of obtaining information, investors tend to rely on reactions in other markets to predict future prices This may not be a reliable source of information as each individual market state is distinctive

2.1.3 Inflation

2.1.3.1 Summary

Inflation is described as the general increase in the price level of goods and services This leads to various effects on the economy such as the decrease in purchasing power because people have to pay more for a similar basket of goods However, inflation does offer both favorable and unfavorable consequences If government can control and use inflation cautiously, it contributes to economic development

Otherwise, if government is in incapable of managing inflation, it may threaten economic stability and development

2.1.3.2 Advantages

Inflation could be a good thing, depending on what causes it and the state of the economy The followings are two circumstances in which inflation brings favorable

influences First, people anticipate that the prices will continue to increase given the

existence of inflation Hence, consumers will attempt to buy now, as much as they could afford, instead of buying later and paying more ultimately This leads to consumers demanding more goods and services, hence factories and companies need to employ more labors to satisfy customers’ demand In this case, inflation decreases unemployment and stimulate economic growth

Second, inflation suggests that deflation is less of a risk When there is a decrease in

the level of prices, people suppose that prices will continue to fall Therefore, they try to limit their purchases goods and services as they are afraid that the prices will fall even more This leads to a drop in the demand of goods and services As businesses adjust their operations accordingly, unemployment rise while wages slump As a result, decreasing income reduces the demand further, leading to even lower prices; deflation is worsened Deflation is therefore considered a bigger evil than inflation

2.1.3.3 Disadvantages

Firstly, it is important to distinguish between expected inflation and unexpected

inflation Expected inflation, which can induce menu costs and shoes leather costs,

is what economic agents anticipate and have accounted for this in their economic decisions Generally, lenders lose in the case of higher inflation than expected, while borrowers lose when inflation is lower than expected This uncertainty in inflation gives rise to a lending premium which then reduces the efficiency of economic activities Unanticipated inflation can generate risk premium in borrowing rates, reduce informational signal of market prices and lead to an

involuntarily transfer of wealth between borrowers and lenders High inflation is usually detrimental to economic growth through the reduction in investments in the economy This is caused by the uncertainty about future prices; so many investors become indecisive and are unable to predict the return on their investments that they will receive in the future

Moreover, a country can become uncompetitive in the international markets when

inflation causes currency depreciation This leads to a decrease in export, a deduction in demand for goods and an adverse effect on the economy

When inflation is high, central banks try to increase interest rate to manage inflation

by reducing money supply As a result, many people and companies face high interest rates on loans They are now responsible for higher interest obligations Moreover, if they are not able to manage their finance well, they will become insolvency or bankruptcy, which may lead to a crisis in the economy

Finally, the worst scenario, which has been researched by many experts, is

hyperinflation Hyperinflation happens when inflation accelerates rapidly and goes out of control When people acknowledge hyperinflation, they anticipate higher inflation As a result, they buy more now to avoid paying higher price in the future; creating shortages of goods As a result, people use up their savings, cash becomes worthless and creditors go bankrupt as loans decrease in value and people are reluctant to make deposits In this case, the economy depresses completely and government collapses, leaving the economy with chaos and disasters

2.1.4 Inflation and Inflation Volatility

Inflation volatility refers to the standard deviation of inflation rates, which is based

on the change in Consumer Price Index, over a calendar year Volatility of inflation represents the dispersion of both expected and unexpected components of inflation Unexpected changes create inflation uncertainty, which produces adverse economic effects referring to as ex-ante and ex-post effects (Golob, 1994) In fact, Milton

Friedman (1977) has argued that inflation volatility may cause more disturbing effects than the levels High volatility of inflation creates conflicts in prices which create a gap between prices prevailing in the economy and market prices without the presence of inflation volatility Because high inflation volatility leads to price volatility, investors would be less willing to invest in such a risky market Specifically, with regards to existing contractual obligation, price uncertainty gives rise to higher risks and change wealth distribution unexpectedly

There also exists a conventional explanation; known as the Friedman-Ball Hypothesis, on how inflation uncertainty changes with inflation involves monetary policy implementations When inflation levels are low, authorities put their effort to maintain it low and stable When inflation levels are high, it is unpredictable whether the government will engage in inflation controls and suffer the costs of recession, and policy makers tend to adopt economic policies to manage inflation Inflation variability increases as a result of uncertainty in monetary policy This justification is also supported by Ball (1992) and Fischer (2002) In contrast, Pourgerami and Maskus (1987) argue that surged inflation induces economic agents

to invest more resources to anticipate future inflation rates better, thus this leads to lower inflation uncertainty

With regards to the sign of the relationship between inflation and inflation uncertainty empirically, Golob (1994), Ball (1992) and Friedman (1977) suggest positive correlation between inflation and inflation uncertainty Consistently, Davis and Kanago (1998), Hartmann and Herwartz (2012) and Kim and Lin (2012) find a positive association between inflation and inflation volatility Lastly, there exists opposing explanations as well as empirical evidences on this relationship; however, the studies supporting a positive association seem to overwhelm Finally, inflation volatility, when used as a measurement, has its limitation which is its inability to distinguish between expected and unexpected portion of the change in inflation

2.1.5 Trade Liberalization and Inflation Volatility

It is challenging to place definitive conclusions on how liberalized trade leads to inflation volatility Given the limitation of the theoretical literature and the scarcity

of researches on this topic, this thesis builds on the explanations proposed by Bowdler and Malik (2015) This section then aims to discuss the two transmission mechanisms through which liberalization of trade may influence inflation volatility

First, openness to trade influences policy makers to alter their viewpoint towards

the costs of inflation deviations from its target, causing an adjustment in authorities’

incentive of policy implementations Second, liberalization impacts the degree of

diversification in consumption and production, wiping out the effects of individual shocks aiming at prices on an aggregate level

Macroeconomic policy implementation is typically associated as a determination of inflation volatility Authorities adjust economic policies according to their stances towards inflation targets and any divergence from their target levels Regular changes in either fiscal policy or monetary policy tend to couple with high volatility

in inflation On the one hand, increased costs of inflation fluctuations create incentives for policy authorities to adopt more disciplined policies in more open economies (Bowdler and Malik, 2015) When local businesses involuntarily adjust their prices too often, their market share will slump as consumers are able to substitute their products with ones that remain more stable in price To avoid this phenomenon, policy makers put their efforts to maintain more disciplined macroeconomic policies, resulting in less volatile inflation However, Caveelars (2009) suggests an extension to this explanation Whether openness promotes more disciplined policies or less disciplined ones depend on the forces that drive trade liberalization Particularly, when technological enhancement implies lower trade costs, the above explanation by Bowdler and Malik holds true In contrast, when openness occurs due to the elimination of import tariff, the portion of government’s revenue collected from tariff is reduced This results in more aggressive monetary policy expansions, which then leads to increases in inflation volatility

One the other hand, openness to trade can affect authorities’ incentive and ultimately inflation behaviors through the examination of the Phillips Curve, or the slope of the output-inflation trade-off in other words In this setting, three main indicative questions are considered: (1) how policy makers’ perception of costs of inflation deviations changes as a result of openness, (2) how openness influences the Phillips Curve, and (3) how inflation, which depends on the conduct of policies and Phillips Curve, behaves ultimately A Phillips curve illustrates the trade-off between unemployment and inflation in an economy The slope of the Phillips Curve represents the magnitude of the increase in inflation for an expansion of aggregate demand When an economy is operating above potential GDP, unemployment is low while inflation rises One idea is that contractionary fiscal policy can decrease aggregate demand and lower inflationary pressures During a recession, in contrast, fiscal policy expansion can stimulate aggregate demand to achieve potential GDP A country can choose between high inflation and low unemployment or vice versa, and this can be achieved by modifying monetary and fiscal policy accordingly There are two opposing models to this mechanism Some economists, including Dornbusch and Krugman (1976), Romer (1993), Rogoff (2004), suggest that liberalized trade produces a steeper Phillips Curve This means that inflation must raise more for a given rise in output since competition drives flexibility in wages and prices Then, policy authorities have less incentive to engage in expansionary economic policy The opposing model, suggested by Borio and Filardo (2007), Fisher (2005), and IMF (2006), argues that trade liberalization flattens the Phillips Curve Openness increases competition (IMF, 2006), leading to firms losing their pricing powers and harder to raise prices, which flattens the Phillips Curve Interestingly, the two views offer different correlation between trade openness and the output-inflation trade-off; yet the same conclusion on the negative effects openness imposes on inflation

Another worth mentioning research is one of Temple (2002) Temple challenges Romer’s finding by arguing that the inflation levels may not reflect the intentions of

policy makers appropriately He considers the relationship between openness to trade and the slope of the output-inflation trade-off a fundamental basis for Romer’s conclusion on the negative relationship between trade liberalization and inflation Temple, however, finds weak evidences for proposed positive relationship between openness and the Phillips Curve This calls for a reconsideration of the conventional explanation for trade openness-inflation relationship

Lastly, Bowdler and Malik (2015) suppose that liberalization of trade encourages consumption diversifications as products and services can be traded freely across countries On an aggregate level, diversification in consumption reduces price volatility, because shocks that affect the markets are canceled out given that they are not perfectly correlated

2.1.6 Financial Liberalization and Inflation Volatility

It is worthwhile to discuss the two basics forces that drive the movements of capital across borders (Tytell and Wei, 2004) First, the degree of capital inflows to a country is influenced by its own policies This implies that capital controls loosening may lead to increases in capital inflows Second, several economic factors, interest rate deviations or business cycle stages for instance, in the country providing capital does affect the capital investment decisions as well In addition, other external factors such as technological systems through which capitals are transmit to other countries and economic situations in other countries In any case, these external factors do not lie in the control of the recipient countries Given the exogenous characteristics of the later factors to one country’s policies, it is arguable that more attention should be given as to how these independent external factors influence the conduct of economic policies In other words, instead of studying the effect of a change in one policy on other government policies, it is more interesting

to see how changes in global setting (e.g financial globalization) shape government's objectives in macroeconomic policies Tytell and Wei (2004)

attempted to study whether financial globalization induces government to conduct better economic policies They term this ―the discipline effect‖ but did not find strong and robust empirical evidence However, they suggest that financial globalization may lead to low inflation policies by authorities Beside Tytell and Wei, Gruben and McLeod (2002) find that liberalization of capital account reduces inflation through more disciplined policies by monetary authorities

In relating to this thesis, the impact financial globalization imposes on authorities’ policy-making decision is also the main channel through which financial liberalization affects inflation The more open an economy is financially, the more incentives a government have to conduct good policies Tytell and Wei (2004) indicate that several policies may be impacted including policy on competition nationally, banking regulations, labor markets, monetary as well as fiscal policies Gupta (2008) propose that financial liberalization reduces government’s incentive to generate inflationary shocks As loose monetary policies impose higher punishments by means of capital outflows when the economy becomes more open financially, authorities tend to employ more disciplined policies When the public recognize this signal, they accordingly alter their expectation on future monetary policies which in turn reduces inflation

One other idea suggests that higher financial globalization increase elasticity of demand for money Liberalized capital account restrictions provide better access to foreign assets and more opportunities for currency substitution, thus increasing the elasticity of money demand (Bartolini and Drazen, 1997) Given the penalty for loose monetary policy the government faces, authority is the less likely to engage in excess printing of money and use more disciplined policies which lower inflation rates The underlying assumption to this argument supposes that governments focus

on inflation rates that are consistent with its balance of payments position In contrast, McKinnon and Mathieson (1981) reach an opposite conclusion using the same argument They propose that government has to fulfill its seignorage revenue

objectives As elasticity of demand for money increases, government drives inflation higher in order to generate intended seignorage revenue

Another contribution to the literature by Razin and Yuen (1995) indicates that the slope of the Phillip Curve (output-inflation trade-off) is steeper with capital controls due to low elasticity of demand for money This implies that a financially closed economy would need to engage in higher inflation for a given reduction in unemployment In other words, a more open economy faces a flatter output-inflation trade-off such that the required increase inflation is smaller for a given decrease in unemployment

2.2 Empirical Evidence

As mentioned previously, there is a range of research papers that have addressed the topics relating to inflation, trade openness and financial openness This section will briefly discuss some of the relevant papers

2.2.1 Inflation and Inflation Volatility

Friedman (1997) gives his Nobel lecture regarding the relationship between

inflation and unemployment Two main arguments were suggested in this lecture First, he revisits the theory on Phillips Curve He evaluates the reasons the inflation-unemployment trade-off is only valid in the short run When the governments demand to reduce unemployment, firms expect that output prices will be higher in the future, therefore firms are prepared to pay higher wages to attract additional labors Initially, workers perceive this increase in wage as an increase in real wage; thus, supply of labor surges, unemployment decreases and output expands Ultimately, workers recognize that real wage remains unchanged as the price levels increase; supply of labor corrects, and the economy goes back to its initial unemployment Second, Friedman suggests that higher inflation may be associated with higher unemployment, which implies a positive slope for the Phillips Curve

He attempts to deliver an alternative theory His argument is that higher inflation

companion with greater inflation volatility and uncertainty Uncertainty influences the economic efficiency to decline, and price fluctuations cause disordered indications on the forms of relative price changes that signal the need for resources

to shift

Kim and Lin (2012) recognize that high and variable inflation cause substantial

costs to the economy such as an involuntary redistribution of wealth between borrowers and lenders, and that it is critical to investigate the relationship between inflation and its uncertainty They suggest that it may be a two-way causality relationship between inflation and inflation uncertainty On the one hand, the paper relies on Friedman (1997) findings such that it is uncertain concerning how government implements monetary policy in high inflation periods, raising greater ambiguity about upcoming inflation On the other hand, they quote Cukierman and Meltzer (1986) paper, arguing that government does face output-inflation trade-off Monetary authority can choose to bring surprised inflation and raise output, or to keep inflation low When there is high uncertainty in inflation, policy makers tend

to have an incentive to motivate output by engaging in discretionary policy and inflation surprise Empirical evidence is conducted using a panel data set of 105 countries from 1965 and 2007 and simultaneous equations model Standard measurement for inflation is used The annual growth rate of CPI and GDP deflator inflation are also used as sensitivity tests Moving average standard deviation of CPI or GDP deflator is used as a proxy for inflation uncertainty Their empirical results support for the hypotheses that the relationship between inflation and inflation volatility has two-way effects

2.2.2 Trade Liberalization and Inflation

Next, I will move on to the researches that are related to inflation and openness This has been a subject with considerable interest and debates both theoretically and empirically I will discuss on both trade and financial openness

Romer’s paper (1993) on openness and inflation is one of the most notable research

on this topic He attempts to extend Barro and Gordon model (1983) and suggests a theory which suggests that openness influences the output-inflation trade-off Focusing on trade openness rather than financial openness, he argues that when the economy is more opened, surprised monetary expansion leads to a more volatile exchange rate, which then creates a higher inflation increase for a given increase in output This reduces monetary authority’s incentive to engage in expansionary monetary policy In other words, openness steepens the Phillips Curve and policy makers face a larger output-inflation trade-off As a result, inflation is supposed to

be lower in more open economies He also provides empirical evidence using IV and OLS estimates for a cross-country dataset of 114 countries over 1973-1988 Inflation measures used in this paper is either the average change in log GDP or GNP deflator annually For countries with unavailable data, he uses change in logarithms of CPI as an alternative measure Openness to trade is measured as average import as a fraction of GDP or GNP He finds statistically significant negative link between trade openness and inflation

Nonetheless, the link between openness to trade and inflation in Romer's relies on

an explanation that ―that a more open country gains less from surprise inflation (and therefore inflates less) because it suffers more from the negative terms of trade effect of an expansion in domestic output‖ (Lane, 1997) The drawback of this explanation is that it applies mostly to large nations, which is large enough to

influence worldwide relative prices Therefore, Lane (2007), using the same theory

and dataset as in Romer's, demonstrates more pronounced effect of trade openness

on inflation when controls for country size

Study that proves a positive relationship between openness to trade and inflation

includes Narayan, P., Narayan, S., & Mishra (2011) They intend to focus on the

determinants of inflation; however, they do find that openness has a positive effect

on inflation Beside the regular economic variables used to study the determinants

of inflation, the authors also consider the effect of remittances and other

institutional variables, which are central bank independence and politics, on inflation Remittances can influence inflation through changes in the following three channels: exchange rates, money supply and balance of payments In the arguments regarding trade openness, Barro and Gordon model, Romer (1993) and Lane (1997) studies are mentioned Inflation and trade openness data is taken directly from WDI Trade openness is measured as sum of exports plus imports as a share of GDP The writers use GMM approach for a panel data set of 54 developing countries between

1995 and 2004 Evidence shows that remittances and trade openness do put upward pressures on inflation

2.2.3 Trade Liberalization and Inflation Volatility

The relationship between trade openness and inflation volatility has not been examined by many scholars Starting off their writing by revisiting opposing

theories by Romer (1993) and Temple (2002), Granato, Lo, Wong (2006) attempt to

provide empirical analysis between economic openness and monetary policy intentions Romer suggests that more openness to trade steepens the Phillips Curve and policy makers have less motivation to intervene monetary policy In contrast, Temple finds little relationship for this association and argues that the level of inflation does not appropriately reflect the intentions of monetary authorities Granato, Lo and Wong reason that the more aggressive the monetary policy is, the less volatile inflation becomes And also, monetary policy does affect inflation persistence As a result, the paper examines the link between openness and inflation based on monetary policy implementations using three variables: inflation volatility, inflation persistence and economic openness Inflation volatility is measured as the variance of inflation, which is the percentage change in CPI quarterly Inflation persistence is estimated using autoregression And, the ratio of imports to GDP is used as the measurement for openness Dataset used include 102 countries over the period ranging from 1949 to 2001 The correlations between openness and inflation

volatility as well as inflation persistence are found to be negative This implies ―a possible connection between economic openness and aggressiveness in monetary policy toward inflation stabilization‖ (Granato, Lo, Wong (2006) In more open economies, the increased cost of inflation volatility raises monetary authorities’ incentive to intervene in order to keep inflation from deviations

The effect of openness on inflation volatility is studied by Bowdler and Malik

(2015) and is also one of a small of number papers on this relationship Although

the effect of openness on inflation volatility depends on the policy makers’ decisions, the sign of this relationship is ambiguous There are two main mechanisms that support for the effect of trade openness on inflation volatility First, openness to trade causes an adjustment in economic policy implementations This is due to the effect that openness imposes on policy makers, who accordingly adjust their view concerning the costs of inflation misalignment Second, liberalization changes the degree of diversification in consumption and productions, causing individual shocks on price to cancel out from an aggregate standpoint Bowdler and Malik carry out their study using an unbalanced panel data set of 96 countries from the 1st quarter of 1961 to the 4th quarter of 2000 They use ordinary least squares, fixed effect, Differenced-GMM and System-GMM to estimate their model System-GMM is found to be suitable with their models due to its ability to solve endogeneity issue In addition, they also add more instruments, together with the two main variables, to have more significant results This paper, which uses a dynamic panel model and controls for endogeneity issue of openness, supplies the evidence for its negative effect on trade openness Researchers suggest notable falls

in inflation volatility in both developed and developing countries since early 1990s This paper contributes two main findings to the literature First, with respect to the countries with more liberalized trade than global average, these countries have lower inflation volatility Second, the developing and emerging countries have stronger negative effects of trade openness on inflation volatility than others

2.2.4 Financial Liberalization and Inflation

Gupta (2008) reasons that worldwide liberalization of capital account during the

1990s and 2000s are associated with disinflation in both developed and developing countries In his journal, he attempts to develop a model to explain the financial openness-inflation relationship theoretically, and then conducts empirical tests on the proposed model His model suggests that capital account openness reduces policymakers’ incentive to create surprised inflation shocks as they recognize the increased costs for undisciplined policies It is argued that undisciplined monetary policy causes the economy to suffer from increased capital outflow In addition, as the economy becomes more liberal, consumers and businesses recognize this fact and change their expectations about future economic policies accordingly This in turn reduces inflation Gupta then conducts an empirical analysis using cross-country panel data set for 163 countries during 1980 and 2003 Inflation data is the log of average inflation based on GDP deflator He takes into account de jure measure of capital account liberalization, which is Chin-Ito index, since he believes

it to be a more appropriate measurement to examine the discipline effect of capital account liberalization Using both Prais-Winstein regression and GMM model to incorporate lagged dependent variable, Gupta finds that liberalization of capital account does impose lower levels of inflation

McKinnon and Mathieson (1981) suggest an opposing conclusion on the association

between financial liberalization and inflation in term of its sign In their essay focusing on the strategies to manage and repressed economy, McKinnon and Mathieson suggest that economic liberalization may benefit an economy initially, but a loss of financial control could lead to price inflation, currency devaluations and negative economic growth A repressed economy, which pertains to most developing countries, often has greatly protective trade policy and heavy capital controls In such a world, since savings mainly consists of currencies and deposits, monetary policy is fundamental as it serves as an intermediary between borrowers and lenders in the economy However, fiscal imbalance influences the conduct of

monetary policy because government in developing countries is usually tied by their revenue constraint to finance government expenditures In the event of high fiscal deficits, government does rely on the amount of revenue generated from seignorage

as it is politically not feasible for government to relax their trade policy or increase taxes Liberalized financial system generally implies an increase in the elasticity of demand for money Hence, government would need to generate a higher increase in

money supply, which involves higher inflation, for a given revenue objective

2.2.5 Trade and Financial Liberalization simultaneously and Inflation

There are also other researches on the effect of trade and financial openness simultaneously, including Ghosh (2014) and Badinger (2008)

The time inconsistency issue, which is the gap between ex-post and ex-ante announced policy objectives, is a popular problem occurring with most central banks all over the world as government involves in monetary policy expansion

This leads to increases in inflation; hence Ghosh (2014) examines the effect of

macro factors on inflation to help policy makers have an optimal decision in inflation adjustments Ghosh’s study is different from previous studies because it takes into account trade, financial openness and exchange rate regimes He supposes that the sign of relationship between trade openness and inflation is ambiguous from other researches On the one hand, some economic experts find that there is negative effect of trade openness on inflation because trade liberalization creates opportunities for domestic market to become more integrative and more competitive with international markets Therefore, the policy makers limit unexpected inflation shocks On the other hand, others find that trade liberalization leads to disparity in the society and economy, hence governments have to spend more on social expenditure to compensate for social costs The increase in expenditure spending boosts inflation Regarding financial openness, the elasticity of demand between national and foreign currencies has increased Hence, there are more disciplines for

policy makers’ adjustment in monetary policy in order to reduce inflation The exchange rate regime is the third factor considered in this paper He supposes that fixed regimes create stable prices in trading of goods, hence disciplined monetary policy is encouraged His study uses a data set of 137 countries with period between

1999 and 2012 and uses GMM estimation method for his model In addition, he also carries on further robustness tests to ensure for his results using de jure regime measures The contribution of this paper is his finding that higher financial openness and fixed regime reduce inflation Otherwise, the negative effects of trade openness on inflation only hold for some countries which have low trade liberalization and high inflation

Badinger (2008) provides evidence on the relationship between globalization and

inflation as well as the output-inflation tradeoff Globalization in this paper is defined as both the trade and financial liberalization Badinger recognizes the conflicting conclusion in the literature with regards to the effect of openness on the output-inflation trade-off and ultimately inflation levels Theoretically, this paper does present the opposing views by scholars regarding the effect openness put on the output-inflation trade-off This was also explained in details in the previous section Then, a comprehensive empirical analysis examines the relationship between openness and output-inflation trade-off as well as openness and inflation Trade liberalization and financial liberalization are then considered simultaneously

to find the link they have with inflation and the trade-off Data used in empirical examination is a cross-sectional dataset, which consists of 91 countries from 1985

to 2004 It is argued that de facto measures are more important in the theoretical point of view, though de jure measures are also considered in the model Least square estimate, including two-stage least square, and IV estimate are used to conduct empirical analysis Badinger finds that both trade and financial liberalization are associated with larger output-inflation trade-off, and ultimately lower the levels of inflation

CHAPTER 3 Data and Methodology

3.1 Data

Emerging markets play a crucial role in the process of globalization in term of their contribution towards the world economic growth and productivity, demographic trends and cultural developments As these countries involve more into different aspects globally and integrate into international trade and finance, policy makers face several challenges, including the change in the nature of inflation process, in adjusting their economic policies according to a new environment This thesis focuses on the relation of interest specifically for emerging market and developing countries

IMF categories 159 countries as emerging market and developing countries as of July of 2017, but data is only available for 142 countries Therefore, this thesis investigates this effect through an unbalanced panel data set of 142 emerging market and developing countries with eight three-year period windows from 1991

to 2014 The time period between 1991 and 2014 is chosen to study in this thesis because this period covers the Asian Financial Crisis in 1997 and the World Financial Crisis in 2007 and 2008 This also includes pre-crisis, during crisis and post-crisis periods All of the data for the main variables as well as control variables

is taken mainly from two databases which are International Financial Statistic (IFS) and World Development Indicator (WDI) from International Monetary Fund (IMF) and World Bank (WB), respectively This thesis includes three main variables namely inflation volatility (VINF), trade openness (TO) and financial openness (FO) Moreover, the two control variables including GDP per capita (RGDP) and government expenditure growth rate (GEXP) are added to the model Besides, I use other variables which are population size (POP), inflation (INF), annual output growth (VOL) and average rate of economic growth (GROWTH) to conduct robustness tests for the models The paragraphs following go through the details of each variable