Dynamic panel estimates show the negative relation between trade openness and inflation found by Romer (1993) but questioned by Terra (1998) became more robust in the 1990s, both among high income OECD and developing countries. Also during the 1990s, openness was associated with less variable inflation and had a stronger disinflation effect in economies with floating exchange rates.Trade

Darryl McLeod

William C. Gruben

English

Research Papers in Economics

 
 
The Openness-Inflation Puzzle Revisited  
 
 
 
 
William C.Gruben
+ and Darryl McLeod* 
 
 
 
+
  Center for Latin American Economics,  Federal Reserve Bank of Dallas,  
P.O. Box 655906, 2200 North Pearl Street, Dallas, TX  75201-2272, USA 
 
*  Department of Economics, Fordham University, 441 East Fordham Road, NY  10458-5158, USA 
 
E-Mail:  william.c.gruben@dal.frb.org; mcleod@fordham.edu 
 
 
 
Dynamic panel estimates show the negative relation between trade openness and inflation found by 
Romer (1993) but questioned by Terra (1998) became more robust in the 1990s, both among high 
income OECD and developing countries.  Also during the 1990s, openness was associated with less 
variable inflation and had a stronger disinflation effect in economies with floating exchange rates.      
 
 
 
 
 
*Corresponding author:     Darryl McLeod 
                                           Economics Department 
              441 East Fordham Road 
                                            NY, NY  10458    USA    
718 817-4063 
                                            mcleod@fordham.edu 
 
  The Openness-Inflation Puzzle Revisited 
 
    
 Romer (1993) finds closed economies tend to have higher inflation.  Central banks in 
economies more open to trade, Romer argues, find currency fluctuations caused by money surprises 
more painful and therefore exercise more restraint than their closed economy counterparts.  While 
some question Romer’s dynamic inconsistency story,
1 the openness-inflation correlation itself has 
generated considerable interest.  Temple (2002) calls it one of the modern “puzzles” of international 
macroeconomics.  But Terra (1998) challenges Romer’s empirical findings, arguing that the 
openness inflation correlation is confined to severely indebted countries and, even then, is only 
evident during the 1980’s debt crisis period.  Romer (1993) himself finds no significant inflation- 
openness relationship among OECD economies.
2 
 This note revisits Romer and Terra’s findings in a more general dynamic panel setting using 
data from the 1990s.  Our results suggest the negative openness-inflation correlation strengthened in 
the 1990s across all country groups.
  And contrary to Terra’s (1998) hypothesis, except during 
1980s, the inflation-openness relationship is more significant among less indebted countries.  More 
open economies also tend to have less variable inflation, albeit only in the 1990s.  Arellano-Bover 
GMM panel system estimates using five-year averages suggest causality runs from openness to 
lower inflation, as Romer (1993) argued.  The disinflation effect of openness appears to be stronger 
in countries with floating exchange rates.  These results support the view that trade openness 
reduces inflation generally, and that it did, in particular, during the worldwide disinflation of the 
1990s. 
                                                 
1 Among the skeptics is David Romer himself, see his Advanced Macroeconomics 2
nd edition, page 492.      
2 Lane (1997), however, finds that after controlling for country size, inflation is negatively correlated with 
openness among OECD countries. Similar results are reported in Table 3 below.    
- 2 - Our panel consists of five-year averages for inflation and import shares over the period 
1971-2000, effectively encompassing Romer and Terra’s 1973-89 cross-country averages.  
Following Terra (1998) we focus mainly on bivariate inflation and openness relationship, albeit in a 
more general dynamic panel framework.
3   Table 1 addresses Terra’s hypothesis regarding the role 
of external debt by separating our panel into severely and less indebted countries and reporting 
results for the 1980s debt crisis period separately.
4  The four upper right entries in Table 1 tell the 
story.  Consistent with Terra (1997), there is a strong inflation-openness correlation among severely 
indebted countries in the 1980s.  But outside the debt crisis period, the pattern reverses. Excluding 
the 1980s, the coefficient for the severely indebted countries is larger: -.30 compared to -.10 for less 
indebted countries, but is no longer statistically significant even at the 10% level. The not-severely-
indebted countries coefficient for the same period is, on the other hand, highly significant.       
Table 2 tests the robustness of the inflation-trade openness relationship. Changes in five-
year average inflation rates and import shares are regressed on lagged values of the same variables, 
plus some time period dummies using Arellano and Bover’s (1995) GMM dynamic panel system 
estimator.  Note that lagged changes in trade shares predict inflation, but the reverse is not true. 
When import shares increase, inflation tends to fall in the next period.  Equation 2.6 tests for 
spurious correlations caused by inflation induced real exchange rate changes.  The openness 
measure in Equation 2.6 is the “open” variable from the Penn World Tables Version 6.1: total 
imports plus exports over GDP.
5   The PWT trade shares are measured in constant international 
                                                 
3  These results are robust to the addition of structural variables such as per capita income, latitude, total PPP 
GDP (size) and regional dummies see Gruben and McLeod (2002) and Lane (1997). However, many of the 
variables used in these cross-country regressions are not available in time series or for the 1990s (Central 
Bank independence measures for example).       
 
 
- 3 - prices, and therefore are less influenced by short-term real exchange rate fluctuations.  Evidently, 
the negative inflation-openness correlation holds for this broader openness measure as well.
6    
Following Romer (1993), a number of models explaining the openness-inflation correlation 
have been proposed.  Lane (1997) and Guender and McCaw (2000) stress nominal rigidities or 
market imperfections that cause nominal exchange rate movements to have real effects.  Similarly, 
Temple (2001) and Bowdler (2003) focus on exchange rate movements that worsen the tradeoff 
between money surprises and unemployment. Equation 2.4 splits the import trade share among 
three classifications of exchange rate flexibility. The magnitude of the inflation-openness 
coefficient increases with the degree of exchange rate flexibility.  The difference between the pure 
floaters and the fixed exchange rate regime coefficient is significant at the 5.1% confidence level.    
Terra (1997) argues that highly indebted countries use seigniorage to pay off debt, a strategy 
that is less inflationary in more open economies.  To test this proposition, Equation 2.3 splits the 
import share variable into three country groups defined by levels of external indebtedness.  The 
coefficient for severely indebted countries is higher than that for the less indebted countries, but 
differences among the coefficients are significant at the 10% confidence level.    
The inflation-openness correlation appears to strengthen in the 1990s.  The time-varying 
coefficients reported in Table 3 suggest that countries most open to trade saw the greatest reduction 
in their inflation rates during the 1990s.
7  Additional evidence for the 1990s is provided by Equation 
                                                 
6 Using the World Bank WDI 2002 imports of goods and services over its PPP GDP estimates yields similar 
results, but the World Bank WDI only includes PPP GDP estimates from 1975 on, so using the PWT 6.1 
openness measures provides a larger data set.  
 
7 / Between the late 1980s and the late 1990s, the weighted average import share for the 118 countries in our 
sample rose from 19% to 24% of GDP while the weighted average inflation rate fell from 70% to 5%.  
 
- 4 - - 5 - 
                                                
2.5 where the dependent variable is now the coefficient of variation
8 for inflation.  After 1985, 
economies more open to trade also had less variable inflation.   
To summarize, the inflation-trade openness correlation appears to have strengthened during 
the 1990s and is more robust than earlier research suggested—extending even to OECD countries. 
Yet why we observe this relationship remains something of puzzle.  David Romer (2000, p. 492) 
seems less convinced this correlation emanates from the “inconsistency of optimal [central bank] 
plans.”  Other explanations are being explored. Bowdler (2003) finds openness makes the short-
term Phillips curve steeper in OECD countries.  Temple (2002) argues that it generally does not.  
Gruben and McLeod (2001) argue openness raises the interest rate elasticity of money demand, 
reducing the optimal inflation tax. Another possible explanation is disinflation contagion: with U.S. 
and OECD inflation falling during the 1990s, the disciplining effect of import competition may 
have enabled more open economies to lower inflation faster.  Whatever its cause, that greater 
openness to trade is associated with lower inflation should provide some comfort to those who fear 
globalization and flexible exchange rates increase macroeconomic instability.  
 
8/ The coefficient of variation is the standard deviation of the log of one plus the inflation rate divided by 
mean inflation for 1986-90, 1991-95 and 1996-2000.      
 - 6 - 
REFERENCES 
 
Arellano, M. and  Bover, O. (1995) Another look at instrumental variables estimation of Error 
Component Models,  Journal of Econometrics 68 , 29-51. 
 
Bowdler, C. (2003) Openness and the output-inflation Tradeoff, Nuffield College, Oxford 
University, Mimeo. 
 
Gruben, W., and McLeod, D. (2001) Capital account liberalization and 1990s disinflation , Center 
for Latin American Economics Working Paper 0101, Federal Reserve Bank of Dallas.  
 
Guender, A., and McCaw, S. (2000) The inflationary bias in a model of the open economy, 
Economics Letters 68, 173-78. 
 
Lane, P. (1997) Inflation in open economies, Journal of International Economics 42, 327-347. 
 
Romer, D. (1993) Openness and inflation: Theory and evidence, Quarterly Journal of Economics 
CVIII, 869-903. 
 
Romer, D. (1998) A new assessment of openness and inflation:  Reply, Quarterly Journal of 
Economics CXIII, 649-652. 
 
Romer, D. (2000) Advanced Macroeconomics, Second edition, (New York, McGraw Hill) 
 
Temple, J. (2002) Openness, inflation, and the Phillips curve: A puzzle, Journal of Money, Credit, 
and Banking 34, 450-68. 
      
Terra, C. (1998) Openness and inflation: A new assessment,” Quarterly Journal of Economics 
CXIII, 641-648. - 7 - 
 
   Table 1    
Inflation and Openness to Trade:  1971-2000 5-year Averages  
  Pooled OLS:                   Period:  1971-2000 
2/  1981-1990  71-80 & 91-00 
 Country  Group  All Years  Debt Crisis  Non-Debt Crisis
1.1  Not Severely Indebted Countries   -0.09 -0.064  -0.10 
    (.022)** (.033)*  (.028)** 
  Number of observations  472  165  307 
1.2  Severely Indebted Countries  -0.61 -1.14  -0.30 
    (0.23)** (0.47)**  (0.23) 
  Number of observations  193 70  123 
1.3 All  Countries  -0.23 -0.35  -0.17 
    (0.05)** (0.11)** (0.058)** 
   Number of observations  665 235  430 
        
 
1/ Standard errors in parentheses. **Significant at the 5% or *10% level. Openness is imports of goods and 
services as a percent of GDP converted to dollars using market exchange rates as reported in the World 
Bank’s WDI 2002 CD-Rom. The sample of countries is Romer’s (1993) 114 countries plus Hungary, 
Grenada, The Solomon Islands and Cape Verde – as added by Terra (1998). The five-year averages include 
1971-75,76-80,…96-00.  Missing WDI deflators and import shares were supplemented with IMF’s 
International Financial Statistics November 2002 CD-Rom data for Bahrain, Cape Verde, Democratic 
Republic of the Congo, Cyprus, Ethiopia, Grenada, Guyana, Jordan, Kuwait, Iran, Liberia, Oman, Panama,  
Solomon Islands, Somalia, Sudan, Yemen,  and Zimbabwe. Taiwan data is from Council for Economic 
Planning and Development, Taiwan Statistical Data Book 2001. The complete data set is available at 
www.fordham.edu/economics/mcleod. 
 
2/ Similar results are obtained for fixed and random effects panel estimates.  Bivariate pooled OLS are 
reported here to be as consistent as possible with the methods of Romer (1993) and Terra (1998). 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 - 8 - 
Table 2:  
Panel Regressions: Five-year Averages 1971-2000 
  2.1  2.2 2.3  2.4 2.5 2.6 
Dependent Variable:  Log   Inflation 
1/ Inflation 
1/ Inflation 
1/ Coefficient Inflation 
1/
 Import  share  log(1+π) log(1+π) log(1+π) of  Variation
6/ log(1+π) 
           
 Estimation Method  GMM-SYS
5/ GMM-SYS
5/  OLS  OLS SUR OLS 
           
  Trade Openness     0.41 
1/ -0.17     -5.0   -0.12 
7/ 
Lagged: previous 5 yr period  (0.20) (.05)     (1.23) (0.03) 
          
  Lagged Inflation   -0.04 0.45     -0.21   
           (previous 5 year period)  (.05) (.14)     (0.65)   
           
 Import Share—LICs 
2/     -0.21      
     (less indebted countries & OECD)     (.046)      
         
 Import Share- SICs     -0.25      
 (Severely Indebted Ctys)     (.063)      
          
 Openness: fixed Rate Regimes
3/       -0.21    
   (import share for fixed regimes)      (0.05)    
          
 Openness: Floating fx Regimes 
3/       -0.3    
   (import share for flex rate regimes)       (.07)    
           
 Constant   1.84  0.67 0.25  0.27 5.85 0.25 
  (.68)  (.19) (0.03)  (.04) (1.91) (.03) 
 Number of Observations  657 659  660 535  328 616 
 Sargan Test (P-value)  0.08 0.34       
 1
st Order Serial-Correlation (p-value)  0.09 0.06       
 Coefficient Difference 
4/  (Wald test)     0.04 0.09    
             (0.05) (.048)       
 1/  To cope with deflation episodes, inflation is measured as the natural log of one plus the average annual change in the GDP deflator. 
 2/ Classification of less, severely and moderately indebted countries follows Terra (1998). Equation 2.3 includes a moderately indebted 
  group coefficient of -.20 (.07) but the difference is less significant statistically than that between less and severely indebted countries  
3/  Classification of countries into fixed, floating and semi-fixed regimes uses LaFluer’s (2002) 8-level classification to classify countries  
    into three groups: fixed, flexible and semi-fixed.  For equation 2.4 the openness coefficient for the semi-fixed group was -.28 (.08). 
      As La Fluer’s regime index is only available 1975-2000, our sample is reduced to five 5-year intervals. 
 4/  The Wald test null hypothesis is equal coefficients for the two import share variables reported above.  The difference and standard   
       error are reported here. The significance levels for the equation 2.3 and 2.4 tests are 36% and 5.1% respectively 
5/ This Arrellano and Bover (1995) system-GMM estimator regresses levels and changes in inflation/import shares on lags of the same    
     variables, using lagged levels as instruments for changes and vice versa.  The Sargan tests validates this instrument set, but this was    
    not the case before we took the log of the import share and added  time period dummies.  The 71-75 and 96-00 time dummies were   
     significant with coefficients of  -.037 (.017) and -.05 (.02) respectively.    
  6/ The coefficient of variation is standard deviation over the mean inflation for each five-year interval.  The sample period for this 
       equation 1986-2000 – prior to 1986 this relationship disappears, due in large part to the extreme variations Latin American inflation.  
 7/  The openness variable in this equation is the Penn World Tables v. 6.1 “openness” variable: imports plus exports over $PPP GDP.  - 9 - 
      
 
 
  Table 3      
Inflation-Openness Over Time 
Openness-Inflation Coefficient by Period 
1/ 
Dependent Variable: log (1+π )  Constant  76-80 81-85 86-90 91-95 96-00 
            
(3.1) No Severely Indebted Countries  0.17 -0.09  -0.07  -0.14  -0.14  -0.19 
(497 observations) 
(0.16)  (0.65)  (0.05) (0.052) (0.051) (0.051) 
            
(3.2) All countries  0.26 -0.28  -0.22  -0.19  -0.17  -0.32 
(665 observations)  (.025) (0.11)  (.084)  (.084)  (0.083)  (0.084) 
            
(3.3) Severely Indebted Countries  0.5 -1.03  -0.8  -0.3  -0.16  -0.74 
(178 observations)  (0.09) (0.45)  (0.35)  (0.35)  (0.31)  (0.31) 
            
(3.4) 27 OECD Countries   0.13  -0.05 -0.07 -0.13 -0.18 -0.21 
(160 observations)  (0.16)  (0.07) (0.61) (0.06)  (0.065)  (0.066) 
         
        
 
1/  Standard errors are in parentheses.  These are OLS estimates for six 5-year intervals, 1971-2000. 
     
 
 
 
 

The openness-inflation puzzle revisited

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics