Inflation in Disaggregated Small Open Economies
High inflation during the COVID-19 pandemic was not limited to the United States and the eurozone, where it reached 8 percent and 8.4 percent, respectively, in 2022. Researchers have devoted much attention to those large economies while, for the most part, overlooking small open economies, which on average experienced an inflation rate of about 10 percent in 2022. This paper focuses on the latter group of countries. Specifically, it studies inflation in small open economies that have production networks to gain insight into how such networks may affect the reaction of a country’s consumer price index (CPI) to sectoral technology shocks, factor price changes, and import price changes.
Key Findings
- In a small open economy, production networks alter the elasticity of that economy’s CPI to changes in sectoral technology, factor prices, and import prices.
- In a small open economy with production networks, indirect exporting (through domestic intermediate inputs) dampens the effect of domestic shocks on CPI relative to an otherwise equivalent closed economy.
- Import price shocks and other foreign shocks are amplified in a small open economy with production networks relative to an otherwise equivalent small open economy without production networks.
Implications
The interaction of trade and production networks matters because in an open economy, production networks amplify the discrepancy between domestic production and domestic consumption through indirect linkages: Non-exporters become indirect exporters, and non-importers become indirect importers. This ultimately affects the exposure of domestic consumers to a different set of shocks. Production networks thus have a first-order impact on inflation in an open economy, and unlike with a closed economy, sales and factor shares are not sufficient statistics for studying how changes in sectoral technology or factor prices pass through into inflation.
Abstract
This paper studies inflation in small open economies with production networks. I show that production networks alter the elasticity of the consumer price index (CPI) to changes in sectoral technology, factor prices, and import prices. Sectors can import and export directly but also indirectly through domestic intermediate inputs. Indirect exporting dampens the inflationary pressure from domestic forces, while indirect importing increases the inflation sensitivity to import price changes. Computing these CPI elasticities requires knowledge of the production network structure because these do not coincide with typical sufficient statistics used in the literature such as sectoral sales-to-GDP ratios, factor shares, or imported consumption shares. Using input-output tables, I provide empirical evidence that adjusting CPI elasticities for indirect exports and imports matters quantitatively for small open economies. I use the model to illustrate the importance of production networks during the COVID-19–related inflation in Chile and the United Kingdom.