Inflation-openness relationship: A Panel approach for developing countries

Abstract

This paper aims at verifying the existence of significant relationship between inflation and openness in the context of the developing countries. The dataset comprises 53 developing countries located at five different regions for the years from 1975 to 2002. With money and quasi money growth, GDP in terms of SDR, different measures of degree of openness, namely, export ratio, import ratio and trade ratio, and dummies for country, year, region and exchange rate regimes as the explanatory variables, a wide range of variants of the basic dynamic specification containing the levels and first lags of all variables have been estimated. The dynamic models were estimated by the system GMM method. The static specifications give results in favour of the existing theoretical and empirical literature, that the openness has a significant negative effect on inflation, but this is clearly seen only in the period after 1989. The analysis of pre-1989 data shows that only the fixed exchange rate regime has had a significant negative effect on inflation. The results of the dynamic specification show that openness does not have any significant effect on inflation if country effects are controlled for, but the lag of the money growth has a significant negative effect hinting that the effect of openness might have been captured in the latter. A notable result in this analysis is that openness affects inflation positively, while its lag affects it negatively. In addition to the panel data analysis, a simple time series analysis of inflation in selected countries has been carried out using ARMA (1,1) model for two different time spans during one of which the country under examination was more open than the other span, to check for any change in the significance of inflation inertia, assumed to be captured by the coefficient of the lag of inflation. The results support the hypothesis that openness might enhance inflation inertia for India and not the other countries.