The Dragging Effect of World Inflation in Small Open Economies

Marco Vega and Diego Winkelried

in Premio de Banca Central Rodrigo Gómez / Central Banking Award "Rodrigo Gómez" from Centro de Estudios Monetarios Latinoamericanos, CEMLA

Abstract: This paper shows the way how persistent world inflation shocks hitting a small open economy can re-weight the importance of domestic and foreign factors in the determination of prices. In this sense, we study why the recently observed global disinflation environment may imply a weakening of the standard interest rate channel of monetary policy to affect inflation. We derive a state-dependent Phillips curve based on translog preferences that make the elasticity of substitution of domestic goods sensitive to foreign prices. With this approach we are able to replicate the dragging effect of global disinflation on domestic inflation, as experienced in small open economies such as New Zealand, Chile and Peru.

Keywords: Monetary policy; Phillips Curve; Market Power (search for similar items in EconPapers)
JEL-codes: D43 E31 E52 (search for similar items in EconPapers)
Date: 2004
ISBN: 968-5696-17-9
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