THE NEW INFLATION EQUATION
April 6, 2007
Inflation varies inversely with growth not only in the domestic economy but also with growth in other countries, say Richard W. Fisher (president and CEO) and W. Michael Cox (chief economist) at the Federal Reserve Bank of Dallas.
The relative importance of domestic and global growth, they say, depends on four factors:
- Country size - The smaller a country's share of the world economy, the more overseas growth tends to reduce domestic inflation.
- Home bias -- Foreign influence on inflation increases as consumers' preference for their own countries' products shrinks relative to imports.
- Ease of substitution -- The rest of the world's impact on domestic inflation rises when consumers view foreign goods and services as suitable alternatives for domestic ones.
- Production tradeoffs -- Foreign growth reduces domestic inflation more when labor displaced by imports is redeployed effectively into home export industries.
Each of these factors in some way gauges the importance of foreign goods in domestic consumption, explain Fisher and Cox. For example: A country that produces everything it needs will find that other countries' output means nothing at all to its prices. A country that consumes only imports will find inflation responds to foreign gross domestic product (GDP) growth alone.
The more imports come into play, the more the world-wide supply of goods matters to the price level. Demand pressures that bid up prices don't build as quickly or as powerfully when consumers can switch between domestic and foreign suppliers, say Fisher and Cox.
Source: Richard W. Fisher and W. Michael Cox, "The New Inflation Equation," Wall Street Journal, April 6, 2007.
Browse more articles on Economic Issues