Ambrogio Cesa-Bianchi, Federico Di Pace, Aydan Dogan and Alex Haberis
The recent sharp rise in energy prices led to an increase in the price of energy-intensive tradables, with inflationary pressures subsequently spilling over to services in many economies. Because services are less traded and have little energy input, some have suggested that this expansion could indicate inflationary pressures. more and more persistent. In this post, we explore the issue through the lens of a stylized two-country model with one tradable and one non-tradable sector. It suggests that after an energy price shock: i) the spread of inflation from goods to services does not necessarily imply more persistent inflationary pressure or a change in long-term expectations, but may instead reflect adjustments through national labor markets; and ii) Inflationary pressures in non-tradable sectors may still have considerable international contagion effects.
Our stylized framework
To analyze the problem, we use a dynamic stochastic general equilibrium model with two countries that are connected through trade and financial links. We refer to countries as ‘home’ and ‘foreign’, as in the economics literature.
Four key features of the model are important to our discussion. First, the countries are lopsided in size, with a foreign economy much larger and relatively more closed than the local economy. Second, both economies are energy importers, where energy is modeled as an exogenous input to production. Third, households in both economies consume domestically produced non-tradable goods (eg, theater) and tradable goods (eg, theater snacks), which may be produced domestically or imported. Fourth, workers can move freely between tradable and non-tradable sectors and have some degree of market power in setting their wages.
We model the energy shock in a simplified way by considering a global input cost shock that affects both domestic and foreign business sectors. We also assume that the shock is more severe at home than abroad. The shock then materializes as an increase in the cost of inputs for snacks, which affects the domestic economy more.
How can an input shock in the tradable sector generate inflation in the non-tradable sector?
To answer this question, we can focus on the impact of the shock on the foreign economy. Because it is large and relatively closed, sectoral spillovers within the foreign economy are largely unaffected by international spillovers and developments in the domestic economy, so we can abstract from the latter.
The immediate consequences of the shock are to increase the prices of tradable goods in the foreign economy. This is because companies in the tradable goods sector are trying to protect their profit margins, which have been squeezed by rising input costs.
For their part, households in the foreign economy reduced their consumption. Demand for tradable goods falls in response to their now higher prices. The demand for non-tradables falls because households prefer to consume them along with tradables: when the price of snacks rises and their demand falls, the demand for theater also falls.
Therefore, the input cost shock is recessive abroad.
As for the labor market, it plays a key role in generating inflationary pressures in the non-tradable sector. To understand why, it is important to note that the increase in the prices of tradable goods reduces the real wages of workers in both sectors. In an attempt to maintain their real income, workers use their market power to restrict their labor supply, raising nominal wages. This process can be seen as a kind of ‘real wage resistance’. Importantly, because wages are common across all sectors, non-tradable firms now face higher labor costs. This is what generates the highest inflation in the non-tradable sector.
Monetary policy in this framework is assumed to be credible and bring inflation to target through an increase in nominal rates.
In summary, we can observe rising inflation in sectors not directly affected by the energy shock as a result of a joint labor market and a form of ‘real wage resistance’. Thus, mutually reinforcing wage and price inflation need not be a sign of de-anchoring inflation expectations, which is ruled out by our assumption of rational expectations and credible monetary policy.
Why might foreign non-tradeables inflation be important to the domestic economy?
The cost shock of global inputs generates internal inflationary pressures in the tradable and non-tradable sectors of the national economy, through mechanisms similar to those of the foreign economy.
But unlike the foreign economy, open economy considerations play a key role in shaping domestic outcomes. The open economy dimension can be summarized in the bilateral real exchange rate (RER), which is determined by two separate components:
where PX and PMETER are the prices of national exports and imports to and from abroad, respectively; and and and and denote the price of tradable and non-tradable goods in the domestic and foreign economy.
It is useful to break down these components and their effects on the national economy in turn.
Starting with the domestic bilateral terms of trade (ToT). In response to shock, this improves (an increase). Note that if we were to explicitly model the third bloc of commodity exporters (where the global input cost shock for snacks originates), PMETER it would now include energy prices and therefore rise significantly, causing a deterioration in domestic aggregate QoQ.
The improvement of the bilateral ToT with respect to the foreign economy reflects our assumption that the global input cost shock for tradable goods affects the domestic economy more severely: the prices of domestically produced snacks rise more than those produced abroad. Other things being equal, the improvement in the ToT is associated with an appreciation of the domestic RER and a deterioration in the domestic trade balance: domestic consumers switch to imported foreign snacks, now cheaper.
Graph 1a shows in a stylized way the relative supply and demand of goods traded abroad in relation to goods traded at home. The largest input cost impact for household snacks is shown here as a drop in the relative supply of household snacks, represented by the inward shift in the relative supply schedule (from the black line to the green dashed line). .
Chart 1a: Bilateral Terms of Trade
Graph 1b: Domestic relative prices
Returning to the internal relative price ratio. As discussed by Broadbent (2017), together with ToT, two other relative prices determine the relative demand (and therefore the allocation of resources) between countries and between the different types of goods within each country. These are the relative prices between non-tradable goods (theater) and tradables (snacks) in the country and abroad, respectively.
Our assumption that the global input cost shock for tradable goods hits the domestic economy more severely implies that the price of theater relative to refreshments falls more at home than abroad (although, in absolute terms, all prices are increasing). This can be seen in stylized form in Figure 1b, which shows the supply and demand curves for non-tradables relative to tradables within a particular economy. The shock is shown as an increase in the relative supply of theater tickets, represented by the outward shift in relative supply times (from the black line to the blue dashed line for the UK and to the red dashed line for the UK). rest of the country). world).
Other things being equal, this movement in relative prices is associated with a depreciation of the RER, which helps to offset the loss of competitiveness due to the higher costs of tradable inputs. Domestic consumers shift away from tradable goods (both locally produced and imported) for non-tradable goods, and do so more than foreign consumers (point C vs. B in figure 1b). In our example, domestic imports of snack foods from abroad fall more than foreign imports of snack foods from the country (ie domestic exports). As a result, the trade balance improves.
In short, the overall response of the TCR is the result of two opposing mechanisms: (i) a ToT mechanism, which appreciates the TCR and leads to a worsening of the trade balance, and (ii) a domestic relative price effect, which depreciates the RER. and leads to an improvement in the trade balance. In our model-based simulations, the ToT effect dominates the impact. The resulting appreciation helps contain inflationary pressures from the input cost shock (through lower imported inflation). However, the worsening of the trade balance contributes to a further drop in domestic production.
The global input shock leads to a global recession, widespread global inflationary pressures, and a rebound in nominal wage inflation. Policymakers therefore face a trade-off: a tighter monetary policy stance to stabilize inflation on target must be balanced by a shortfall in output.
We show that price dynamics in the non-tradable sector can have important implications for the RER. In the absence of the non-tradables sector, the RER would move one-for-one with the ToT and would therefore appreciate more than in our baseline simulations. A greater appreciation would imply lower imported inflation but, at the same time, a greater drop in economic activity.
Ambrogio Cesa Bianchi works in the Bank’s Global Analysis Division, Federico Di Pace works in the Research and Structural Policy Team of the Bank, Aydan Dogan and you have alex I work in the Bank’s Global Analysis Division.
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