Tailwinds and headwinds: how does growth in the BRICs affect inflation in the G7?

In this paper, we analyse the impact of a persistent productivity increase in a set of countries – which we think of as the BRIC economies – on inflation in their trading partners, the G7. In particular we want to understand conditions under which this shock can lead to tailwinds or headwinds in the economies of trading partners. We build a three-country DSGE model in which there are two oil-importing countries (home and foreign) and one oil-exporting country. We perform several experiments where we try to disentangle the importance of different factors that can shape inflation dynamics in the home country when the foreign country is hit by a persistent productivity shock. These factors are wage stickiness, the role of the oil sector and its share in both consumption and production, foreign monetary policy and the degree of completeness of financial markets. We find that the tailwinds effect, lowering inflation in the home economy, dominates the headwinds effect as long as there is scope for borrowing and lending across countries and the foreign country’s production is not too oil intensive.