Trade fragmentation, inflationary pressures and monetary policy

Summary

Focus

This paper investigates how trade fragmentation influences inflationary pressures and examines the necessary monetary policy responses to maintain inflation at target levels. It uses a heterogeneous agent, open economy model that incorporates imperfect international risk-sharing to capture both demand and supply side effects of trade fragmentation.

Contribution

The paper provides a general equilibrium analysis of the macroeconomic effects of trade fragmentation. Conventional assessments of the impact of fragmentation on inflation often ignore the general equilibrium impact through demand. While the direct partial equilibrium effect of fragmentation might be inflationary through a contraction of aggregate supply, the general equilibrium effect could dampen inflation, as lower real incomes weigh on aggregate demand. The effects of fragmentation on inflation dynamics and the direction of monetary policy cannot be separated from its impact on the natural real interest rate. The paper also explores the role of household heterogeneity and the degree of openness in shaping the macroeconomic response to trade fragmentation.

Findings

The study finds that trade fragmentation is not necessarily inflationary. Its impact on inflation and the appropriate monetary policy response depend on how aggregate demand adjusts to lower real incomes and lower productivity. Three different scenarios highlight the findings. First, if import prices gradually increase, real income losses and a decrease in consumption lead to a reduction in aggregate demand, resulting in lower domestic inflation and a decrease in the natural real interest rate. Second, a sudden and permanent increase in import prices creates a temporary period of stagflation, with lower consumption and higher inflationary pressures. Third, a persistent fall in productivity in tradable sectors increases tradable inflation but is offset by a decrease in non-tradable inflation. While the impact of this shock is ambiguous, in this study's calibration, the natural rate falls and demand and supply balance in a way that implies a non-inflationary shock.

Abstract

How does trade fragmentation affect inflationary pressures? What is the response of monetary policy needed to sustain inflation at target? To answer these questions, we develop a heterogeneous agent, open-economy model featuring imperfect international risk-sharing. The model captures both the demand and supply side effects of fragmentation. It illustrates how the impact of fragmentation on inflationary pressures and the appropriate policy response depends not only on the direct effect of higher import prices on supply but, crucially, on how aggregate demand adjusts in response to lower real incomes and productivity stemming from fragmentation.

JEL classification: F12, F15, F41, F62

Keywords: monetary policy, trade fragmentation, open economies, inflation, heterogeneity, globalisation

• Discussion by Agnès Bénassy-Quéré