Abstract
This Selected Issues paper analyzes the impact of globalization on United Kingdom’s inflation and relative prices over the last decade. The IMF’s Global Economy Model (GEM) is used to estimate the relative importance of the various factors argued to have influenced the evolution of inflation and relative prices over this period. The key result is the significantly different impact of the shock on relative prices in the United Kingdom compared with the United States and the Euro area.
I. U.K. Inflation and Relative Prices Over the Last Decade: How Important Was Globalization1
A. Introduction
1. Although inflation in the United Kingdom, the Euro area and the United States has been low and stable over the last decade, there has been an interesting difference in the composition of inflation. While goods price inflation has generally been below service price inflation in all three, in the United Kingdom, this has been significantly more pronounced with goods price deflation offsetting strong and fairly stable inflation in services prices. This feature is even more notable if one focuses on core inflation and core goods prices (Figure 1). The net effect has been that the relative price of services has increased significantly more in the United Kingdom than in either the United States or the Euro area.
Inflation Stylized Facts
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Inflation Stylized Facts
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Inflation Stylized Facts
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
2. The IMF’s Global Economy Model (GEM) is used to estimate the relative importance of the various factors argued to have influenced the evolution of inflation and relative prices over this period. A four-country/region version of GEM is used (see (Laxton and Pesenti, 2003) and (Hunt, 2005) for detailed descriptions of GEM’s structure and dynamic adjustment properties). The model is calibrated to represent the United Kingdom, the United Sates, the Euro area and emerging Asia. The factors considered include: an increase in tradable goods productivity growth in emerging Asia (the direct effect of globalization); an industrial country productivity growth differential between the tradable and nontradable sectors; an increase in U.K. tradable goods distribution efficiency; a permanent increase in the U.K. real effective exchange rate; and a permanent increase in the U.K.’s public sector consumption of nontradable goods.
B. Direct Effect of Globalization
3. This shock experiment has been calibrated to match two aspects of the recent historical period.
The first is the relative 50 percent increase in the level of emerging Asia’s GDP (Figure 2) with the driver of that growth differential concentrated in the tradable sector (Table 1).
The second is the approximately 5 percentage point increase in the share of goods from emerging Asia in industrial countries’ imports (Figure 3).
Average Annual Labor Productivity Growth, 1995 to 2004
Average Annual Labor Productivity Growth, 1995 to 2004
| U. K. | U. S. | Euro Area | Emerging Asia | |
| Tradables | 2.93 | 3.50 | 2.99 | 6.46 |
| Nontradables | 1.54 | 1.99 | 0.19 | 2.59 |
Average Annual Labor Productivity Growth, 1995 to 2004
| U. K. | U. S. | Euro Area | Emerging Asia | |
| Tradables | 2.93 | 3.50 | 2.99 | 6.46 |
| Nontradables | 1.54 | 1.99 | 0.19 | 2.59 |
Real GDP Index
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Real GDP Index
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Real GDP Index
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Share of Imports from Emerging Asia
(as a percent of total imports)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Sources: Eurostat and Direction of Trade Statistics.Share of Imports from Emerging Asia
(as a percent of total imports)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Sources: Eurostat and Direction of Trade Statistics.Share of Imports from Emerging Asia
(as a percent of total imports)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Sources: Eurostat and Direction of Trade Statistics.4. The shock is implemented assuming that people must learn about its persistence. When agents have perfect foresight under long-lived shocks that have significant implications for wealth, rational expectations models, like GEM, can produce adjustment dynamics unlike that seen in actual data (see Hunt and Rebucci, 2006). To address this and generate closer-to-real-world adjustment dynamics, the shock is implemented assuming that each period, agents must generate forecasts of the shocks’ persistence. In this shock, the learning is calibrated so that agents initially learn slowly about the persistence. However, as the duration of the shock increases, agents start to learn more quickly.
5. The key result is the significantly different impact of the shock on relative prices in the United Kingdom compared to the United States and the Euro area. The resulting solution paths for a number of key macro variables are presented in Figure 4. The first point to note is that the level of emerging Asia’s GDP increases by roughly 50 percent over ten years. The U.K. relative price of nontradables increases by roughly 6 percent versus just over 1 percent in the United States and the Euro area. This occurs for two reasons. First imports from emerging Asia make up a larger share of the final consumption bundle in the United Kingdom. Second, the real effective exchange rate in the United Kingdom appreciates while the real effective exchange rates in the United States and (eventually) in the Euro area depreciate.2 The appreciation in the U.K. effective exchange rate exerts downward pressure on the prices of all U.K. imports. Because the United Kingdom is much more open, this has a large positive wealth effect and demand for nontradable goods increases more, further increasing the relative price of nontradables. Similarly, the shock results in more downward pressure on core CPI inflation in the United Kingdom because of the greater share of low cost imports in the U.K. consumption bundle. However, it is interesting to note that the downward pressure on inflation gradually dissipates. This reflects the fact that agents eventually learn about the persistence of the productivity increase in emerging Asia and the implications for the future prices of imported tradables. The consequent implications for lifetime wealth leads households to increase current consumption, eventually generating mild excess demand.
An Increase in Tradable Sector Productivity Growth in Emerging Asia
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
An Increase in Tradable Sector Productivity Growth in Emerging Asia
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
An Increase in Tradable Sector Productivity Growth in Emerging Asia
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
C. Including the Additional Factors
6. Although globalization has had a considerably larger impact in the United Kingdom, it explains only a portion of the different inflation performance. The simulation results from the previous section suggest that the direct effect of globalization can explain about 25 percent of the increase in the relative price of nontradable goods in the United Kingdom over the last ten years. Adding the remaining factors cited as important for driving relative price and inflation developments over the last decade helps explain the remainder. These factors include:
the within-country productivity differential between the tradable and nontradable sectors (Table 1);
a 15 percent improvement in distribution efficiency in the United Kingdom phased in over 10 years;
an increase, over 10 years, in U.K. public demand for nontradable goods matching the observed 4 percentage points increase in the U.K. public expenditure-to-GDP ratio;
an appreciation of the U.K. real effective exchange rate similar to that seen over the 1996-97 period;3 and
to capture uncertainty, the shocks are again implemented assuming that agents must form forecasts of the shocks’ persistence. For all but the exchange rate shock, agents learn slowly.
7. These shocks combined go a long way toward explaining several key stylized facts. In the combined simulation, the relative price of nontradables in the U.K. rises by just over 80 percent of the observed increase. The simulated increase in U.K. GDP suggests that these factors have accounted for a significant portion of U.K growth over the last ten years. The simulated 4.1 percentage point increase in the share of nontradables in U.K. GDP (not shown) matches the 4 percentage point increase in the data.
Combined Experiment
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Combined Experiment
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
Combined Experiment
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
8. The simulation results suggest that although globalization accounts for an important part of the increase in U.K. relative service prices and the moderation in core inflation, U.K. specific factors also played a significant role. The direct effect from competitively priced imports from emerging Asia is estimated to account for approximately 25 percent of the increase in the relative price of services. The within U.K. productivity gap between the tradable and nontradable sectors and increased efficiency in the U.K. distribution sector account for roughly another 35 percent. The increase in public sector demand for nontradable goods is estimated to account for just under 10 percent and just over 10 percent is estimated to arise from the 1996–97 increase in the U.K. real effective exchange rate. Overall the model and the shocks considered do a reasonable job of explaining why relative service prices have evolved differently in the United Kingdom. Because of its relative size and openness, globalization has had a larger impact in the United Kingdom, but other factors are also important to understand the behavior of inflation and relative prices.
U.K. Relative Price of Nontradables
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
U.K. Relative Price of Nontradables
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
U.K. Relative Price of Nontradables
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A001
D. Conclusions
9. Looking ahead, policymakers need to recognize of how the key factors that have driven inflation over the last decade may evolve. First, these factors have exerted considerable downward pressure on inflation which the simulation results suggest allowed the policy interest rate to be on average notably below the neutral rate. Should these factors wane, the average policy rate over the past decade may not provide a reliable guide to judge the degree of tightness in monetary policy. Second, even if productivity catch-up in emerging Asia and efficiency gains in U.K. distribution are processes that will continue for some time, these simulation results also suggest reasons for caution. As agents learn about the persistence in these processes, the downward pressure on core CPI inflation starts to dissipate. This occurs because households current consumption starts to become more influenced by their expected future real income gains arising from more competitively priced tradable goods. The resulting demand pressures may start to diminish the downward impact that these factors have on overall inflation. The monetary authority will need to be cognizant of this risk.
References
Hunt, B., 2005, “Oil Price Shocks: Can They Account for the Stagflation in the 1970s?” IMF Working Paper 05/215 (Washington: International Monetary Fund).
Hunt, B., A. Rebucci, 2005, “The U.S. Dollar and Trade Deficit: What Accounts for the Late 1990s?” International Finance, Vol. 8, No. 3, pp 399–434.
Laxton D., and P. Pesenti, 2003, “Monetary Policy Rules for Small, Open, Emerging Economies,” Journal of Monetary Economics, Vol. 50, pp 1109–46.
Prepared by Ben Hunt. A more detailed version of this paper is forthcoming as an IMF Working Paper.
The appreciation of the U.K. real effective exchange rate reflects the absolute levels of trade from emerging Asia. Although as a percent of GDP, imports from emerging Asia are larger in the United Kingdom than in either the United States or the Euro area, the levels of imports from emerging Asia are significantly larger in the United Sates and the Euro area. Consequently, to ensure that current accounts are sustainable in the long run, emerging Asian currencies must appreciate more relative to the dollar and the Euro than the pound. The pound, although it also depreciates relative to emerging Asian currencies, appreciates sufficiently against the Euro and the dollar to more than offset the effect in the real effective exchange rate.
To construct these charts, the impact of a smaller exchange rate appreciation than seen historically was scaled up and added to the simulation combining all the other factors. This was necessary since it was not possible to solve the model with an exchange rate appreciation shock as large as occurred historically.
