Openness, Inflation and Output Under Alternative Monetary Policies: A Structuralist Approach

Date01 May 2019
Published date01 May 2019
DOI10.1177/0015732519831802
Subject MatterArticles
Openness, Inflation
and Output Under
Alternative Monetary
Policies: A Structuralist
Approach
Rilina Basu1
Nandini Das1
Ranjanendra Narayan Nag2
Abstract
This article theoretically revisits the issue of how trade openness and inflation
are interconnected in the light of conduct and optimal design of monetary policy.
Central banks in open economies all over the world face a problematic dilemma
when it comes to providing a nominal anchor to the economy in the sense that
they have to choose between monetary targeting and inflation targeting. The
experience has been varied worldwide with respect to these alternative policies in
containing inflation. Different dimensions of openness like fully flexible exchange
rate and capital mobility have also had significant impacts on the outcomes of
policy changes. In this paper, we have constructed two theoretical open macro-
economy models using the AD-AS framework under regressive expectations.
The first model considers interest-rate targeting incorporating Taylor rule,
whereas the second one deals with monetary targeting. The models show that
alternate monetary policy rules do not change the basic results of different
macroeconomic policies, although the underlying transmission mechanisms are
quite different.
JEL Codes: E12, E31, E43, E52, F41
Keywords
Inflation, interest rate, monetary policy, openness, macroeconomy
Article
1 Department of Economics, Jadavpur University, Kolkata, West Bengal, India.
2 Department of Economics, St. Xavier’s College (Autonomous), Kolkata, West Bengal, India.
Corresponding author:
Rilina Basu, Department of Economics, Jadavpur University, Kolkata, West Bengal 700032, India.
E-mail: banerjee.rilina@gmail.com
Foreign Trade Review
54(2) 75–90, 2019
© 2019 Indian Institute of
Foreign Trade
Reprints and permissions:
in.sagepub.com/journals-permissions-india
DOI: 10.1177/0015732519831802
journals.sagepub.com/home/ftr
76 Foreign Trade Review 54(2)
Introduction
With increased globalization during recent decades, there has been a continuous
debate on the consequence of trade openness on inflation. This article revisits this
issue in the light of conduct of monetary policy. Inflation has remained as one of
the major concerns for policymakers, especially central banks.1 To achieve non-
inflationary sound economic growth, it is imperative to look into the relationship
between international trade and inflation as this has far spread consequences.
This brings us to the controversial topic of analysing the sources of inflation.2
The issue has caused a persistent debate among structuralists and monetarists.
While the monetarists suggest that inflation is an outcome of an increase in money
supply, structuralists argue that it is the institutional and/or structural impedi-
ments, which lead to inflation in the economy (Campos, 1961). The monetarist
theory of inflation is based on the quantity theory of money, which has its premise
on exogeneity of money supply and neutrality of money. These assumptions sug-
gest that an increase in money supply induces inflation and the impact of changes
in money supply is almost entirely reflected in the price level since money is
neutral. This assumption of exogeneity of money supply was questioned by
Sargent and Wallace (1973), Frenkel (1977) and Jacobs (1977) who proposed that
there is a bi-directional causality between money supply and inflation.3 On the
other hand, the structuralist school suggests that inflation is a natural outcome of
rapid economic development and growth process and results primarily from non-
monetary factors (see Chenery, 1975; Noyola, 1956; Olivera, 1964; Sunkel,
1960). These economists suggest that with increasing demand in a rapidly grow-
ing economy, there may arise structural bottlenecks which cause inflationary pres-
sures in the economy.4 These structural impediments can be analysed in the light
of demand shift hypothesis, export instability hypothesis, agricultural bottleneck
hypothesis and foreign exchange scarcity hypothesis.
Given the alternative theories, there has been a serious debate on the impact of
inflation on growth. While the structuralists believe that inflation is essential for
economic growth, monetarists argue for a single point focus on inflation saying
that if inflation is controlled, one can expect stable economic growth. Low infla-
tion in their view increases foreign capital inflows and financial savings. Hence,
the degree of openness also plays a key role in determining inflation5. It becomes
essential to analyse how inflation in trading partners affects the domestic macro-
economic variables.
In India there has been an increasing degree of inflation post-2004–2005. This
was triggered by a rise in demand conditions (especially non-government) and
unmatched supply situations. This was further accompanied by the increases in
prices of food and fuel in 2008.6 However, the financial crisis of 2008 acted as a
negative demand shock, thereby lowering inflation for a short period. However,
the drought of 2009, followed by the uneven rainfall in 2010, raised food prices
once again. The Middle East political crisis also raised the inflation pressures.
Once the central bank resumed its inflation-controlling monetary policies, the
maximum CPI inflation has been at 5.77 per cent, precariously closer to the upper

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