Is the Impact of Digitization on Domestic Inflation Non-Linear? The Case of Emerging Markets

The impact of major macroeconomic factors on domestic inflation has long been theorized and analyzed by economists. Nevertheless, the literature that studies the impact of digitization as an important determinant for lower and more stable inflation in both advanced economies and emerging markets is very thin. In this paper, we use panel data from the World Bank World Development Indicators and the Digital Ecosystem Development Index developed by Katz and Callorda (2018), on a sample of 54 advanced economies and emerging markets over the period 2004-2018. Starting from a traditional Phillips Curve with inflation expectations and output gap, we estimate a System Generalized Method of Moments (GMM) panel model. In our estimation of the model, we find a negative statistically significant non-linear (quadratic) relationship between the domestic inflation rate and the digitization index, with a definite cutoff point. This result supports the hypothesis that digitization may initially lower inflation, however, once digitization reaches its cutoff level further improvement in digitization leads to an increase in the rate of inflation. We subsequently re-estimate the main model using eight specific digitization pillars for infrastructure of digital services, digital connectivity, digitization of household, digitization of production, digital industries, factors of digital production, digital competitive intensity, and regulatory framework and public policies. Notably, we find a negative statistically significant non-linear relationship between the domestic inflation rate and all eight pillars of digitization for both the full sample and the emerging markets sample. Because the highest deflationary impact of digitization is derived from the digital infrastructure and factors of digital production, the policy priorities we emphasize include expanding network coverage, increasing fixed and broadband download speed, boosting telecommunications and education investments, as well as strengthening intellectual property rights, enhancing investments in R&D, and incentivizing innovation and patenting. However, our results show that deflationary effects of the improvement in digitization are smaller in emerging markets versus the full sample and that the entire effect of digitization in emerging markets is reinforced by the investment in human capital and the improvement of governance. Hence, our policy recommendations for emerging markets are directed towards maximizing school enrollments, controlling corruption, rule of law, and voice and accountability measures to recoup the maximum benefits of the improvement in digitization on domestic inflation.