Applying the Concept:  Globalization, Trade, and Inflation                             

If you look at the label the shirt or blouse you are wearing, chances are they were imported Philippines or Cambodia, or somewhere else in Asia.  The reason is that it is less costly to manufacture the clothes in places where labor is inexpensive.  And the result is that clothes are cheaper here.  Trade lowers prices.  Does it also lower inflation?

This is not a course in international trade, but the basics are straightforward.  The best way to understand trade is to think about it as a form of productivity enhancing technological progress. Shifting production of clothes from domestic factories to foreign ones is the same as US producers finding new, cheaper technology. And improvements in technology increase potential output.  That is something we understand.

Looking at Figure 22.13 on page 604 we see that an increase in potential output does drive inflation down, at least temporarily.  And, as discussed later in Chapter 23 (starting at the bottom of page 610), increases in productivity present policymakers with the opportunity to reduce inflation permanently if they wish. 

Our conclusion is that globalization and trade do reduce inflation. Is the effect likely to be large?  To see, we can look at a few numbers.  First, a substantial part of what any of us spend on imported goods pays for domestic transportation and the retail store where we bought it.  The amount of domestic content varies substantially, but we can estimate that it averages about one-third.[1]  Second, roughly 8% of a typical household’s purchases are imported goods.  Putting these two together, we have that imported goods prices have a roughly 6% expenditure weight.  That’s roughly the same importance as “Education and Communication” or “Medical Care.” (Take a look at Your Financial World: Understanding Inflation Statistics on pages 528-529.) 

How big an impact can something this size have on overall inflation? Well, if import prices are dropping at 5%, which is what happened in 2001, then this would reduce inflation by about 0.3 percentage points per year.  Even with inflation averaging a fairly low 2% per year that is a modest impact.