International Finance 12:3, 2009: pp.

301–320
DOI: 10.1111/j.1468-2362.2009.01248.x

Globalization, Domestic Inflation

and Global Output Gaps:
Evidence from the Euro Area

Alessandro Calza
European Central Bank.

Abstract

This paper tests whether the proposition that globalization has led to
greater sensitivity of domestic inflation to the global output gap (the ‘global
output gap hypothesis’) holds for the euro area. The empirical analysis uses
quarterly data over the period 1979–2003. Measures of the global output gap
using two different weighting schemes (based on purchasing power parities
and trade data) are considered. We find limited evidence that global
capacity constraints have explanatory power for domestic consumer price
inflation in the euro area. Based on these findings, the prescription that
central banks should specifically react to developments in global output
gaps does not seem to be justified for the euro area.

I. Introduction
In the years immediately preceding the start of the current financial crisis, many
industrialized economies experienced low and stable inflation despite a number
I am very grateful to Stephane Dees and Filippo di Mauro for kindly sharing the data set of
their study and to Andy Filardo, Benoı̂t Mojon, Warwick McKibbin and Mark Wynne for
helpful comments. The paper has benefited from a number of interesting suggestions by two
anonymous referees and the Associate Editor Fabio Ghironi. The views in this paper are
those of the author and should not interpreted as representing those of the European Central
Bank.
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302 Alessandro Calza

of developments that the experience of the late 1960s and the 1970s had led us
to associate with the emergence of inflationary pressures. These developments
included declining slack in product and factor markets, protracted monetary
and fiscal policy accommodation as well as rising commodity prices. This
unusual combination of events has prompted researchers to investigate whether
the traditional linkages over the business cycle between inflation and its
domestic determinants may have weakened over the past two decades.
As evidence of structural changes in the inflation process, various studies
have reported estimates of aggregate supply equations or ‘Phillips curves’
showing that the impact of measures of domestic capacity constraints on
inflation has declined over time and, in some cases, become insignificant.1 In
professional jargon, it is customary to refer to these empirical findings as
evidence that the Phillips curves have ‘flattened’.
Several scholars and policy-makers have recently argued that globaliza-
tion may have contributed to explaining the reduced responsiveness of
inflation to capacity constraints at home in the past few years.2 For instance,
Bank for International Settlements (BIS 2005, p. 20) notes that ‘Increased
globalisation could well mean that domestic factors have become less of a
determinant of inflation in individual countries’. In a similar vein, Helbling
et al. (2006) argue that ‘Globalization has contributed to reducing the
sensitivity of inflation to domestic capacity constraints in advanced econo-
mies over the past couple of decades [. . .]’. Trade openness, international
competition in factor markets and financial integration are among the main
channels through which globalization is believed to have reduced the
sensitivity of inflation to domestic capacity constraints.
At the same time, as economies have become more open and globalized,
external factors may play a bigger role in the determination of domestic
inflation dynamics. As a result, some authors have suggested that monetary
policy-makers aiming to maintain price stability should pay closer attention
to measures of global capacity utilization (see e.g. Fisher 2005). This
hypothesis (the so-called ‘global output gap hypothesis’3) has become

1
See for instance Helbling et al. (2006), Pain et al. (2006) and Roberts (2006).
2
Recent contributions include BIS (2005), Fisher (2005), Greenspan (2005), Helbling et al.
(2006) and Borio and Filardo (2007). Additional explanations of why inflation may have
become less responsive to domestic macroeconomic conditions include increased commit-
ment to price stability by central banks, liberalization and deregulation of product markets,
structural reforms of labour markets (particularly, the introduction of more flexible wage-
setting mechanisms) and productivity growth reflecting advances in the IT industry.
3
As pointed out by a reviewer, the term ‘global output gap’ often used in this literature is not
correct since the domestic economy under consideration is by construction excluded from it.
Thus, this ‘global’ measure in practice refers to cyclical conditions in the rest of the world.

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 Globalization, Domestic Inflation and Global Output Gaps 303

increasingly popular with the press. Thus, The Economist (2005) argues that
‘[. . .] in forecasting inflation central banks now need to pay less attention to
domestic shifts in unemployment and capacity utilisation and much more to
the global balance between supply and demand’, while Business Week (2006)
dramatically concludes that ‘[. . .] the era of a purely domestic monetary
policy is over’.
Likewise, it has been argued that traditional models of the inflation
process that mainly focus on domestic determinants (though they may also
allow for external influences through import prices, exchange rates, etc.)
have become less relevant in globalized economies. The results of a study by
Ciccarelli and Mojon (2005) arguing that in industrialized countries inflation
has become a ‘global’ phenomenon have been interpreted as providing some
support to this view.4 In addition, Dees et al. (2007) find that foreign
consumer price inflation has a statistically significant impact on domestic
inflation in some economies. Furthermore, Boivin and Giannoni (2008) find
evidence of correlation between US inflation and various sets of foreign
common factors.5
The hypothesis that domestic inflation has become sensitive to foreign
cyclical conditions has important implications for the formulation of
monetary policy, which certainly explains why a number of European and
US policy-makers have recently taken an interest in it (see for instance Kohn
2005, 2006; Bean 2006; Papademos 2006, 2007; Yellen 2006; Bernanke 2007;
González-Páramo 2007; Viñals 2007). In particular, one question often raised
by policy-makers is whether an increased dependence of inflation on global
conditions may raise the sacrifice ratio, that is the output loss required to
bring inflation back in line with price stability in case of unacceptable
deviations, thereby rendering it costlier to stabilize inflation. A more
theoretical concern is whether globalization could in the limit undermine
the ability of national central banks to control the dynamics of inflation,
forcing monetary authorities to change the way they conduct monetary
policy, possibly by engaging in greater international policy coordination.
This paper aims to contribute to the debate on the effects of globalization
on inflation by providing fresh empirical evidence on the information
content of foreign output gaps on domestic consumer price inflation in

4
To illustrate their argument, the authors compute various measures of global inflation and
show that, on average, these measures can explain around 70% of the variance of inflation in
a sample of 22 OECD countries.
5
However, Boivin and Giannoni (2008) note that the degree of correlation and its
development over time vary depending on the definition of prices considered and that
only in the case of the GDP deflator, the foreign factors contain significant information
above and beyond that contained in domestic common factors.

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304 Alessandro Calza

the euro area. Indeed, the empirical evidence on the globalization hypothesis
is fairly mixed, possibly reflecting to some extent the uncertainty surround-
ing global output gap measures.6 Most existing studies focus on the United
States: Garner (1994), Orr (1994), Tootell (1998) and Ihrig et al. (2007) find
that excess foreign capacity has little or no effect on US domestic inflation;
by contrast, Gamber and Hung (2001) and Borio and Filardo (2007) obtain
the opposite result, with Wynne and Kersting (2007) also reporting evidence
of a positive correlation between the cyclical component of US inflation and
the global output gap.
The only empirical evidence for the euro area is that provided by Borio
and Filardo (2007). Based on estimated Phillips curves, the authors find that
the global output gap influences euro area inflation. However, they also show
that their results are not robust to the inclusion of additional explanatory
variables (e.g. changes in oil and import prices) in the equations, suggesting
that the relationship between euro area inflation and the global output gap is
rather weak. Our empirical analysis, based on Phillips curves augmented by
the contemporaneous foreign output gap estimated over the 1979–2003
period, also finds little evidence in support of the hypothesis that global
output gaps have explanatory power for euro area inflation.
The evidence for other countries is equally ambiguous: Borio and Filardo
(2007) estimate Phillips curves for 15 industrialized countries and find that
in most of these economies the addition of global capacity measures
significantly increases the explanatory power of the models. However, their
results are challenged by Ball (2006) and Ihrig et al. (2007), who perform
similar empirical analyses for a slightly narrower sample of countries, and by
Pain et al. (2006) using a system of error correction models for a sample of
21 Organisation for Economic Co-operation and Development (OECD)
economies.7 In particular, Ihrig et al. (2007) argue that the results of Borio
and Filardo (2007) for a number of countries are rather sensitive to re-
specifications of the inflation model.
Some studies have also looked into the theoretical robustness of the global
output gap hypothesis and its potential policy implications. For instance,
Sbordone (2007) develops a model in which increased trade integration can
boost market competition and generate real rigidity factors that can
ultimately influence the slope of the Phillips curve. The author argues
that, while in principle increased trade integration could through this
channel reduce the sensitivity of aggregate inflation to output fluctuations,
in practice the increase in the number and variety of goods observed in the
6
See Wynne and Solomon (2007) for a discussion of the various challenges inherent in the
calculation of global production capacity and slack.
7
Ball (2006) and Pain et al. (2006) also include the United States in their samples.

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 Globalization, Domestic Inflation and Global Output Gaps 305

United States in the last 20 years is unlikely to have caused a quantitatively

significant reduction.
A study by Ball (2006) stresses that globalization may cause variations in
the relative prices of goods and services, but not systematic changes in the
general price level, which is determined in the long run by monetary policy.
While acknowledging that large shocks to relative prices could, under certain
assumptions regarding nominal rigidities, lead to protracted variations in
the overall inflation rate, he concludes that the changes in relative prices
induced by globalization have been too small and smooth to meet those
conditions. More generally, Woodford (2007) analyses the implications of
globalization in financial, final goods and factor markets for monetary policy
in the context of a new Keynesian model of an open economy. He concludes
that even under the assumption of significantly more complete global
integration than is experienced in practice, national central bankers are
unlikely to lose the ability to control the dynamics of inflation.
This does not mean, of course, that policy-makers should not pay
attention to globalization. A recent study by Boivin and Giannoni (2008)
examines the effect of globalization on the transmission mechanism of
monetary policy shocks to the US economy in recent years. They find
little evidence of changes in the initial response of inflation compared
with previous decades, but they do find a decline in the response’s
persistence after the two-year horizon. The latter finding is a useful reminder
of the fact that the current wave of globalization is relatively recent and that
it may take more time and data before its impact on the inflation process
fully emerges.

II. Data Issues

Our empirical analysis is based on quarterly data on consumer prices and
real GDP for 26 advanced and developing economies (the euro area plus 25
individual countries) covering the large majority of world output over the
sample period 1979:2–2003:4.8 While it would be difficult to establish the
exact start of the current wave of globalization, various key indicators of
globalization (such as trade, FDI and the size of international capital
markets) gained momentum at the start of the 1980s and rapidly accelerated
throughout the 1990s, suggesting that the starting date of our sample period
should be adequate.
8
The foreign countries covered are Argentina, Australia, Brazil, Canada, Chile, China, India,
Indonesia, Japan, Malaysia, Mexico, New Zealand, Norway, Peru, Philippines, Saudi Arabia,
Singapore, South Africa, South Korea, Sweden, Switzerland, Thailand, Turkey, the United
Kingdom and the United States.

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306 Alessandro Calza

The data on the euro area are sourced from Fagan et al.’s (2005) Area
Wide Model. The euro area GDP data are obtained by aggregating national
accounts data for the original 11 euro area member countries sourced from
OECD and BIS up to 1995:4 using GDP weights at purchasing power parity
(PPP) rates; thereafter, real GDP is given by the official area-wide Eurostat
statistic (including Greece from 2001:1). Similarly, national data on CPI
sourced from OECD and BIS are aggregated to produce the euro area index
up to 1995:4; thereafter, the Harmonized Index of Consumer Prices (HICP)
produced by Eurostat is used. The combined CPI/HICP series has been
seasonally adjusted using X12-ARIMA. Data on non-euro area countries are
sourced from Dees et al.’s (2007) global VAR model. In order to test the
robustness of the results, in some of the regressions we also include
quarterly changes in poit , a logarithmic index of US-dollar-denominated oil
prices converted into euros at market exchange rates.
Foreign output is computed by aggregating data on the 25 foreign
economies using two alternative sets of weights: (1) trade weights derived
from bilateral trade statistics and (2) GDP weights based on PPPs. While
most previous studies of the effect of foreign capacity constraints on
inflation have tended to use weights derived from trade statistics, Borio
and Filardo (2007) also consider alternative weighting schemes, including a
set of PPP-based weights.9
More specifically, considering the euro area as the domestic economy,
f
foreign aggregate output Yt is defined as the weighted average of real GDP
Yjt over the 25 foreign economies indexed by j ¼ 1; . . . ; 25:

f
X
25
Yt ¼ wj Yjt : ð1Þ
j¼1

The foreign output gap is defined as the deviation of aggregate foreign real
f
GDP Yt from its potential level. In order to compute the foreign potential
level, we run the Hodrick–Prescott filter directly on the data on aggregate
foreign output. Similarly, the euro area output gap is defined as the deviation
of real GDP from its potential level, obtained by applying the Hodrick–
Prescott filter to area-wide output.10 As suggested by Kaiser and Maravall
(1999), in order to mitigate the well-known end-of-sample problem of the
Hodrick–Prescott filtering procedure, the output series are preliminarily
9
See Borio and Filardo (2007) for a detailed discussion of the pros and cons of several
alternative weighting schemes.
10
An indirect approach, followed for instance by Tootell (1998), consists of first computing
the individual output gaps of the country’s main trading partners and then aggregating them
using trade weights.

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 Globalization, Domestic Inflation and Global Output Gaps 307

extended by eight quarters by means of forecasts using ARIMA models

(specified and estimated using the econometric package Tramo).
In the case of trade weights, wj is given by the average share of country j in
the exports and imports of the euro area over the period 1999–2001.11 Based
on these data, the United Kingdom and the United States are the euro area’s
largest trading partners, with shares of around 24% and 23%, respectively. A
second-tier group of trading countries with smaller but still sizeable shares
comprises Switzerland (9%), Japan (7%), and Sweden and China (both with
individual shares just below 6%). Among the remaining trading partners, no
country has an individual share above 3%. Thus, the bulk of the euro area’s
bilateral trade is accounted for by developed economies.
A potential limitation of our approach is that bilateral trade statistics do
not take account of third-country effects that may also be relevant to assess
the importance of economic developments in foreign countries. An addi-
tional caveat is that we use weights derived from the average structure of
bilateral trade over a fixed period rather than using time-varying weights.
The use of fixed weights presents some advantages in terms of lower
volatility, but may give rise to distortions for some countries (particularly
the emerging economies), if the trade flow structure is changing rapidly.
Under the alternative PPP-based weighting scheme, wj is given by the
share of country j in the aggregate value of GDP of the foreign countries
considered (converted into a common currency using 2005 PPPs sourced
from IMF). While the weight of Japan (10%) is in line with the trade-based
measure, this is not the case for the United States and most of the euro area’s
trade partners. For instance, the PPP-based weight of the United Kingdom is
less than 5%, while the individual PPP-based weights of Switzerland and
Sweden fall below 1%. By contrast, China accounts for around 18% of
foreign income. Other emerging countries, such as India and Brazil, play a
small role in euro area bilateral trade, but account for sizeable shares of
world income when PPP-based weights are used.
For illustrative purposes, Figure 1 shows both the euro area domestic
output gap and the foreign output gaps computed under the two alternative
weighting schemes. While the developments in the euro area and foreign
output gaps were relatively synchronized in the late 1970s and early 1980s,
they significantly differed throughout the second half of the 1980s and most
of the 1990s. However, the differences in developments became less
pronounced towards the end of the 1990s and at the start of this decade.
The global output gaps computed under both trade and PPP weights co-

11
wj is given by the sum of euro area imports from and exports to country j in total euro area
imports and exports. The trade data used for the computation of the trade-based weights are
sourced from Direction of Trade Statistics, 1999–2001, IMF.

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308 Alessandro Calza

3% Domestic Foreign (trade weights) Foreign (PPP weights) 3%

2% 2%

1% 1%

0% 0%

–1% –1%

–2% –2%

–3% –3%
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Figure 1: Euro area domestic and foreign output gaps (as a percentage of potential output)
Note: The output gaps are percentage deviations of real GDP from their potential levels
as estimated using the Hodrick–Prescott filter.

move over most of the sample period, though there are periods (e.g. the mid-
1980s and early 1990s) during which the differences between the two series
become rather significant.

III. Phillips Curves Augmented by Global Output Gaps

Before presenting the results of the empirical exercise, it is worth noting that
the analysis focuses on headline consumer price inflation (plotted in Figure
2) rather than core inflation because the former is the relevant measure for
the formulation of the European Central Bank’s (ECB’s) inflation objective.
Indeed, the ECB has defined price stability as an annual increase in the
headline HICP of below 2% in the medium term.
As noted by Issing (2003), the ECB acknowledges that some measures of
core inflation can provide useful indications to central banks on longer-term
inflation trends. In addition, Vega and Wynne (2003) find that a trimmed
mean measure of core inflation has good predictive power for headline
inflation at policy-relevant horizons. However, in the ECB’s view as
described in Issing (2003), these advantages are offset by some drawbacks
of core inflation measures, particularly the uncertainty surrounding their
estimation, low transparency compared with the official headline statistic
and, for the exclusion-based measures, the arbitrary removal of consump-
tion goods and services that enter the representative consumption basket of

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 Globalization, Domestic Inflation and Global Output Gaps 309
12%

8%

4%

0%

–4%
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Figure 2: Headline inflation (percentage points)

Note: Inflation is given by the annualized quarterly change in consumer prices.

euro area households. More generally, he argues that the key advantage of
core inflation measures, namely their capacity to remove temporary relative
price fluctuations induced by volatile items or by temporary factors, is less
relevant in the euro area, where the medium-term horizon of the ECB’s
definition of price stability prevents it from reacting to short-term inflation
volatility.
More recently, some central bankers (e.g. Bean 2006) have warned that, as
a result of globalization, some traditional measures of core inflation
(notably, the exclusion-based measures) may produce a distorted picture
of price developments. On the one hand, such measures include items, such
as imported manufactured goods, that have become cheaper as a result of
increased trade competition. On the other hand, they exclude those
commodity-related items, such as energy and food, whose prices have
significantly risen as a result of strong demand stemming from the
integration into the global economy of emerging Asia and of the former
socialist countries in Central and Eastern Europe. Thus, it has been argued
that the headline measure may prove a more accurate indicator of the overall
impact of globalization on the inflation dynamics.

A. Backward-Looking Phillips Curves as in Rudebusch and

Svensson (1999, 2002)
We analyse the effect of foreign cyclical activity on domestic inflation in the
modelling framework of Phillips curves augmented by foreign output gaps.

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310 Alessandro Calza

Theoretical support to the inclusion of foreign output gap in open-economy

Phillips curves for consumer price inflation is provided by Razin and Yuen
(2002), Woodford (2007) and Zaniboni (2008).12 While this is an admittedly
simple framework that cannot fully capture all the channels through which
the global cycle affects domestic prices, it may nevertheless shed light on its
impact elasticity for euro area inflation.
More precisely, we consider an augmented version of the backward-
looking specification of the Phillips curve model used in Rudebusch and
Svensson (1999, 2002):
X
3
f
pt ¼ c þ apj ptj1 þ byht1 þ gyt1 þ et ; ð2Þ
j¼0

with pt ¼ 4ðpt  pt1 Þ denoting the annualized quarterly inflation rate (with
pt the consumer price index in natural logs), yht the domestic output gap and
f
yt the global output gap. The equation relates the inflation rate to its lag
values and those of the domestic and foreign output gaps.13 The inclusion of
lagged inflation can be interpreted as implying the assumption of adaptive
inflation expectations.14
The model is estimated using the two alternative sets of weights for the
global output gap. Table 1 reports only the estimates of the coefficients b and
g, including standard errors robust to autocorrelation and heteroscedasti-
city. The estimates indicate that, regardless of the weighting scheme used,
the foreign output gap has no explanatory power for euro area headline
inflation.15 While this finding would seem to be consistent with the
expectation that large economies should be relatively less sensitive to
external spillovers, it should be noted that the euro area is fairly open in
terms of trade compared with other large economies and, more generally,
that external developments may also have an impact on domestic inflation
through additional channels, such as increased international competition in
12
In particular, Zaniboni (2008) shows that globalization may influence aggregate consumer
price inflation also through shift terms stemming from deviations from the law of one price
that vary depending on the assumption for export price-setting used.
13
Unit root tests suggest that inflation can be treated as I(0) over the sample period.
14
Backward-looking Phillips curves are vulnerable to the Lucas critique and may be
unsuitable to model the anti-inflationary credibility of central banks nowadays, but they
do present some advantages in terms of empirical fit to the data.
15
The estimates are fairly robust to the addition of oil price changes (as a proxy for supply
shocks), with neither the magnitude nor the statistical significance of the coefficients of the
domestic and foreign output gaps significantly changing. Because of the unavailability of a
sufficiently long series for prices of imports from outside the euro area, we were unable to
test the robustness of the estimates to changes in extra-area import prices.

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 Globalization, Domestic Inflation and Global Output Gaps 311

Table 1: Estimates of Parameters of the Domestic and Foreign Output Gaps

of Backward-Looking Phillips Curves (as in Rudebusch and Svensson 1999,
2002) Augmented by Foreign Output Gaps
Foreign output gap measure
Trade weights PPP weights
Dependent variable b g R2adj b g R2adj

(A) Headline inflation 0.05 0.12 0.90 0.08 0.09 0.90

(0.09) (0.12) (0.09) (0.12)
(B) Inflation adjusted for mean breaks 0.10 0.20 0.48 0.14 0.20 0.48
(0.11) (0.11) (0.11) (0.10)
Notes:  and  denote statistically significant at the 5% and 10% critical levels, respectively.
Standard errors in parentheses. Equations estimated with OLS using the Newey–West covariance
estimator (with truncation lag set to 3) over the sample period 1979.1 to 2003.3. Inflation adjusted
for mean breaks is based on the estimated break by Corvoisier and Mojon (2005). PPP, purchasing
power parity.

product and factor markets.16 Besides, these estimates lend little support to
the traditional relationship between domestic output gaps and inflation, with
the good empirical fit of the model mostly reflecting the strength of the auto-
regressive component of inflation over the period considered.
It has been suggested that the explanatory power of global output gaps for
inflation may be obscured by the disinflation process (see e.g. Borio and Filardo
2007). In addition, some authors have argued that the structural decline in
inflation since the 1980s may have reflected breaks in the mean of nominal
variables, mainly reflecting monetary policy regime shifts (see for instance Stock
and Watson 2003). This issue is relevant for our empirical analysis since
structural breaks might undermine the stability of the backward-looking Phillips
curves, ultimately invalidating the reliability of the estimated coefficients.17
In order to address these concerns, model (2) is re-estimated allowing for
breaks in the mean of headline inflation:
X
Nbk X
3
f
pt ¼ c þ cbk þ apj ptj1 þ byht1 þ gyt1 þ et ; ð3Þ
bk¼1 j¼0

where Nbk denotes the number of mean breaks over the sample period. On
the basis of a formal test, Corvoisier and Mojon (2005) identify one
16
According to ECB (2008, p. 89), the combined value of euro area exports and imports of
goods and services amounted in 2006 to around 42% of GDP, compared with approximately
32% and 28% for Japan and the United States, respectively.
17
However, it should be noted that the results of Hansen’s (1992) LM test of individual
parameter constancy show no evidence of instability in the estimated coefficients of the
models for headline inflation reported in row A of Table 1.

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312 Alessandro Calza

structural break in the mean of euro area consumer price inflation in mid-
1985. The timing of the break is consistent with evidence of shifts
in the dynamics of inflation and the structure of the economy for individual
euro area countries by Gagnon and Ihrig (2004) and Rapach and
Wohar (2005)18 and for the area as a whole by Batini (2006). In particular,
Batini interprets the structural break as evidence of a shift in the monetary
policy regime, as it coincided with the evolution of the European exchange
rate mechanism (ERM) from a ‘soft’ to a ‘hard’ exchange rate parity
agreement. In fact, only when the fluctuation bands were narrowed
and parity realignments became less frequent, the ERM became more
effective in reducing flexibility in exchange rates and acting as a monetary
stabilization tool.
The last row of Table 1 presents the estimated parameters b and g
from a model conditional on a break in mid-1985. The main difference
compared with the unconditional model for headline inflation is that the
point estimates of the coefficients of the foreign output gaps (under
both trade and PPP weights) are now larger and have become statistically
significant at the conventional significance levels. Therefore, foreign output
gaps seem to have explanatory power for inflation in the euro area, once we
allow for a break in the mean of inflation in the mid-1980s.
One possible explanation for the difference between the results of the
conditional and unconditional models relates to the interpretation of the
break in the mean of inflation as a monetary policy regime shift. Indeed,
failure to control for a monetary regime shift in the inflation model may lead
to an inaccurate representation of the dynamics of inflation and, in
particular, of the magnitude and speed of its responses to changes in
potential explanatory variables, such as the foreign output gaps. A caveat
concerning these results is that to the extent that the structural break in
inflation reflected a regime shift in monetary policy, the use of models of the
inflation process that do not allow for forward-looking inflation expectations
may not be appropriate. Thus, in the next section we consider a forward-
looking specification by Gerlach and Svensson (2003) that explicitly tackles
the modelling problems stemming from the structural decline in inflation
over the last few decades.19

18
In particular, Gagnon and Ihrig (2004) find evidence of an inflation regime shift at the end
of 1984 and of a subsequent decline in the exchange rate pass-through for several euro area
countries. Similar evidence of a regime shift in inflation and interest rates for selected euro
area countries is provided by Rapach and Wohar (2005).
19
We also considered a hybrid New Keynesian Phillips curve, but it did not provide a
satisfactory empirical representation of the inflation dynamics over the sample period
considered.

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 Globalization, Domestic Inflation and Global Output Gaps 313

B. Forward-Looking Models as in Gerlach and Svensson (2003)

The issue of how to model the behaviour of euro area inflation since the
1980s in a forward-looking framework is addressed by Gerlach and Svensson
(2003) using the following model:

ptþ1 ¼ c þ petþ1;t þ byht þ az ztþ1 þ etþ1 ; ð4Þ

in which petþ1;t indicates the expectation in quarter t of inflation in quarter

t11, and ztþ1 a vector of exogenous variables.20 Inflation expectations are
influenced by the central bank’s time-varying inflation objective p ^t and by
the current deviation of inflation from this objective:

petþ1;t ¼ p
^tþ1 þ ap ðpt  p
^t Þ; ð5Þ

where ap 2 ½0; 1 is a parameter related to the degree of credibility of the

central bank’s commitment to its inflation objective (taking the value 0 when
the commitment is fully credible and 1 when the central bank’s lack of
credibility implies that deviations of current inflation from the objective feed
into expectations).
One complication of the model is that it requires the formulation of an
area-wide inflation objective even before the ECB came into existence. In
order to address this issue, the authors assume that before 1999, the
objective of the national central banks of the future euro area was to bring
inflation down to levels in line with the Bundesbank’s ‘implicit’ inflation
objective.21 Given the relatively large initial inflation differential between
Germany and most other euro area countries, the process of convergence
towards the Bundesbank’s objective was gradual, though it gained momen-
tum as the national central banks’ commitment became increasingly
credible. Since January 1999, the euro area’s average inflation objective
has been pinned down by the ECB’s quantitative definition of price

20
This specification differs from more standard forward-looking Phillips curves in that it
includes expectations for current inflation formulated in the previous period rather than on
(possibly discounted) current expectations about future inflation. However, the authors
argue that this specification of the expectations formation mechanism allows this model to
provide a better representation of how monetary policy-makers’ views of the desirable rate
of inflation can influence private sector inflation expectations (see equation (5)). In the long-
run equilibrium, the inflation rate is given by the central banks’ inflation objective.
21
The Bundesbank never published an official inflation target. However, it used to release
indications on its desired inflation rate under different labels (e.g. ‘unavoidable inflation’ or
‘medium-term price assumption’). Following Gerlach and Svensson (2003), we use these
indicative figures as the Bundesbank’s ‘implicit’ inflation target (1979–80: 4%, 1981: 3.75%,
1982–83: 3.5%, 1984: 3%, 1985: 2.5%, 1986–96: 2%, 1997–98: 1.75%).

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stability.22 Thus, the evolution of the euro area’s inflation objective p

^t over
time can then be described as follows:

p ^btþ1 ¼ ltþ1t0 ð^
^tþ1  p ^bt0 Þ;
p t0  p ð6Þ

where p^bt denotes the ‘implicit’ inflation objective of the area’s anchor central
bank (Bundesbank until 1998; ECB thereafter), l the rate of convergence of
the euro area inflation objective towards the Bundesbank objective, and t0
is the date at which the process of inflation convergence started (1981:1
according to Gerlach and Svensson’s dating). The combination of (4), (5)
and (6) yields the empirical model to estimate:
h i
ptþ1  p ^btþ1 ¼ c þ ltþ1t0 ð^
p t0  p ^bt  ltt0 ð^
^bt0 Þ þ ap pt  p ^bt0 Þ
pt0  p

f
X
3 ð7Þ
þ byht þ gyt þ aqj Dqtþ1j þ etþ1 ;
j¼0

f
where we have added the foreign output gap yt as an explanatory variable
and we have replaced the vector of exogenous variables ztþ1 with the current
and three lags of oil price inflation (as measured by quarterly changes in qt ,
an index of US dollar-denominated crude oil prices converted into euro at
market exchange rates) in order to control for the effect of energy price
movements.
We estimate the equation in one step using the non-linear square
estimator. The results show that the coefficient of the domestic output gap
is highly significant (see Table 2). By contrast, the coefficient of the foreign
output gap is not statistically significant and has the wrong sign, regardless
of the weighting scheme used for its computation. The estimated coefficients
are fairly close to the original estimates by Gerlach and Svensson (2003) over
a shorter sample period. In particular, the estimates of the parameters
describing the initial deviation of the euro area inflation objective from the
reference central bank’s objective and the related rate of convergence as well
as of the coefficient of the domestic output gap are very similar, while the
estimated coefficients of the credibility parameter are slightly higher than in
those authors’ closest specification (though the results of a Wald test show
that the differences are not statistically significant).
22
The ECB does not publish a point definition of price stability, but rather a range of
admissible inflation rates (an HICP annual inflation rate of ‘below 2%’ over the medium
term). However, as part of the review of its monetary policy strategy, Issing (2003) clarified
that it specifically aimed at an inflation rate of ‘below but close to 2%’. Thus, for the purpose
of the empirical analysis, we set p ^bt equal to 1.9% from 1999. However, our results do not
change significantly if we assume an inflation objective of 1.5%, as in Gerlach and Svensson
(2003) (that pre-dated the ECB’s clarification of its desired inflation level).

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Table 2: Estimates of Selected Parameters of Phillips Curves (as in Gerlach

and Svensson 2003) Augmented by Foreign Output Gaps
Foreign output gap
Trade weights PPP weights

b 0.269 0.247
(0.11) (0.10)
g  0.086  0.060
(0.11) (0.09)
l 0.954 0.953
(0.01) (0.01)
^bt0
^ t0  p
p 0.061 0.061
(0.00) (0.00)
ap 0.475 0.477
(0.09) (0.09)
aq0 0.007 0.007
(0.00) (0.00)
aq1 0.001 0.001
(0.00) (0.00)
aq2  0.002  0.002
(0.00) (0.00)
aq3 0.004 0.004
(0.00) (0.00)
c  0.000  0.000
(0.00) (0.00)
R2adj 0.88 0.88
Notes: ,  and  denote statistically significant at the 1%, 5% and 10% critical levels,
respectively. Standard errors in parentheses. Equations are estimated with NLS using the Newey–
West covariance estimator (with truncation lag set to 3) over the sample period 1981.2 to 2003.3.
PPP, purchasing power parity.

C. Summary of the Empirical Analysis

We can summarize the main findings of the empirical exercise as follows:
first, the estimated standard backward-looking Phillips curves based on
realized headline inflation fail to support the claim that global output gaps
should enter the inflation equation. In contrast, foreign output gaps seem to
have explanatory power for the movements in inflation once we control for
one estimated break in its mean in the mid-1980s. However, when we use a
Phillips curve model allowing for forward-looking inflation expectations and
a more sophisticated treatment of the shift in monetary policy and inflation
regimes experienced over the last few decades, the foreign output gap loses
its explanatory power.
Thus, we conclude that the evidence from the euro area in support of the
global output gap hypothesis is limited. In particular, this evidence seems to

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316 Alessandro Calza

be rather sensitive to the treatment of inflation to account for the structural

decline in inflation in recent decades and, as noted by Ihrig et al. (2007) for
other economies, fairly dependent on the specification of the inflation
model. A caveat concerning these results is that they are obtained using
reduced-form single equations that may not be able to disentangle the
specific effect of globalization on the inflation dynamics from other factors
that may have contributed to flattening the Phillips curves over the same
period. In addition, given the relatively recent acceleration in globalization,
it may be too early to identify its impact on the inflation process using
traditional econometric techniques.
Interestingly, the evidence for the euro area as a whole seems to be signifi-
cantly weaker than that provided by some studies for some of its individual
members.23 A potential explanation may be related to aggregation factors,
namely the fact that the empirical evidence of a link between domestic
inflation and global capacity constraints seems to be particularly elusive for
Germany (possibly reflecting the more relevant influence of the country
reunification process and progress in European regional economic integra-
tion on national macroeconomic developments over the sample period
considered). Given the relatively large weight of this country in the euro area
aggregates, the results for Germany may significantly influence those of the
area as a whole. Another explanation is that when computing the global
output gaps for the individual euro area countries, authors may not
distinguish between developments in other euro area members and those
in countries outside the European Monetary Union. If so, the global output
gaps for the euro area countries may also capture – perhaps to a rather large
extent, given the strength of regional integration – cyclical developments
within the euro area. Finally, an additional explanation relates to the earlier-
mentioned observation that bilateral trade data suggest that the bulk of euro
area trade is accounted for by other developed economies rather than
emerging countries. Thus, a measure of aggregate output gap in other
developed areas, particularly the United States and European countries
outside the euro area, may be more relevant for analyses focusing on the
influence of external cyclical developments on euro area inflation than the
global output gap.24

23
I am grateful to an anonymous referee for drawing my attention to this issue and to some
of the possible explanations.
24
However, this argument ignores to some extent the fact that developments in emerging
economies may influence economic conditions in the euro area through other channels, such
as commodity prices and the threat of foreign competition on wage and price setting in the
euro area economy.

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 Globalization, Domestic Inflation and Global Output Gaps 317

IV. Conclusions
There is increasing interest in understanding the channels through which
globalization has influenced the inflation process in recent decades. The
reason for such interest has been clearly spelled out by the President of the
Federal Reserve Bank of Dallas and member of the Federal Open Market
Committee Richard Fisher (2005):
One cannot make monetary policy without being aware of the forces of
globalization acting upon our economy.
Some authors and policy-makers have recently suggested that one of the
main channels through which globalization has affected the inflation process
is by increasing the sensitivity of domestic price developments to foreign
macroeconomic conditions, particularly capacity constraints abroad (see e.g.
BIS 2005; Fisher 2005; Helbling et al. 2006; Borio and Filardo 2007). This
proposition has been accompanied by the recommendation that central
banks aiming to maintain price stability should pay close attention to
developments in global output gaps. Both the original proposition and the
policy prescription have been popularized by newspapers commanding wide
international circulation, such as The Economist and Business Week.
This paper has aimed to provide fresh empirical evidence on this
hypothesis for the euro area. In order to do so, we have estimated different
specifications of Phillips curves augmented by global output gaps. Overall,
we find limited evidence that measures of global capacity constraints have
explanatory power for domestic consumer price inflation in the euro area.
The key policy implication of our findings is that, while central bankers
should certainly be alert to global monetary, financial and real developments
and their implications for price stability at home, the prescription that they
should specifically react to developments in global output gaps does not
seem to be justified.
A caveat concerning these results is that they are obtained using reduced-
form single equations, while the assessment of the effect of globalization on
inflation dynamics may require a more structural approach. In addition, the
current wave of globalization is relatively recent and its impact on the
inflation process may not yet have emerged fully.

Alessandro Calza
European Central Bank
Kaiserstrasse 29
60311 Frankfurt am Main
Germany
alessandro.calza@ecb.europa.eu

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318 Alessandro Calza

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