Globalization And The Federal Reserve

Abstract

A group of developing countries including China, India and Mexico entered the global marketplace post-1980 making a major contribution to disinflation in the U.S. and other developed countries. Movement by developing countries toward free trade led to unexpectedly large gains from specialization and exchange including the contribution to global disinflation through flows of goods, capital, technology and in particular abundant labor. These gains from trade led to a slowing in U.S. cost-push inflation pressures and enhancement of productivity gains. Gains from free trade have been widespread, with benefits accruing to both developed and developing countries in the period since 1980. In comparison, gains from trade were restricted primarily to developed economies in the 1945 to 1980 time period. 

The Federal Reserve and other central banks followed monetary policies conducive to the post-1980 period of disinflation but the contribution to disinflation through gains from trade does not seem to be incorporated into the monetary policy of central banks.  In Japan, disinflation turned into deflation and Germany’s disinflation is on the verge of doing the same. Deflation concerns are also voiced in the U.S. The premise of this paper is that the overshoot from the price stability objective to deflation fears or outright deflation on part of the Federal Reserve and other major central banks is due to gains from trade with developing countries. Policy implication -- the Federal Reserve and other central banks need to increase the quantity of money at a more rapid pace than would normally occur to account for the contribution to disinflation from gains from trade among developed and developing countries.