Around the turn of the decade, low inflationary pressures in many emerging market and industrial countries prompted some to argue that China was bringing down prices in the rest of the world by exporting cheap goods to more mature markets. More recently, as inflationary pressures have started to build up around the globe, these arguments have been turned on their head, with some asserting that demand from China is now pushing up prices in the rest of the world. What's going on? A new IMF Working Paper looks at the empirical evidence and finds some intriguing, and unexpected, linkages.
How can a country export inflation or deflation? After all, isn't inflation in any country a monetary phenomenon determined by domestic policies? The short answer is that it is theoretically possible for countries to export and import inflation or deflation, and there is empirical evidence that they do so. In fact, when there was a global system of fixed exchange rates (such as during the gold standard era), it was not uncommon to see periods of synchronized deflation in a number of countries, as falling prices in the reserve country led to falling prices in others. And, more generally, for any relatively small open economy with a pegged exchange rate, domestic inflation will tend to be determined to a large extent by inflation in its trading partners.
This phenomenon of exporting inflation or deflation can also occur for a country with a flexible exchange rate regime, provided the exporting country is large. For example, deflationary pressures could be exported directly when exports of final goods, whose prices in the domestic currency of the exporter are falling, directly lower the import price indexes of other countries. Deflation could also be exported indirectly if cheaper final goods lower prices in other countries because they adversely affect demand in those countries when producers lose markets and profits. Also, cheaper exports to third countries could affect the cost structure of enterprises in those countries, enabling them to reduce the prices of their exports. Similarly, inflation brought on by demand pressures in a country could increase imports from its trading partners, reducing domestic supply and causing inflation in the exporting economies.
A number of these arguments have been used to claim that China has exported deflation or inflation. Some said that during the boom-bust cycle of the...