External competition flattens the Phillips Curve

Abstract

In this paper we elaborate an open economy Phillips curve (OEPC) with micro-founded analysis, in which external competition significantly impacts the domestic inflation rate. This influence is transmitted through two channels: a) the gap between the current and potential growth of imports, and b) real exchange-rate misalignment. We estimate this OEPC by applying two econometric techniques, panel regressions and PVAR accompanied by impulse/response analysis. A sample of 15 advanced economies is used with data for the period 1994-2017. The results from both methodologies endorse the validity of this theoretical relationship and suggest that international competition reduces the pricing power of domestic firms, thereby curbing inflationary pressures. We also find that the slope of the OEPC has significantly declined in the years after the Great Recession.

Keywords

• Open economy Phillips curve
• RER misalignment
• Cross-sectional dependence
• PVAR
• impulse/response analysis.