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Capital Mobility and the Output-Inflation Tradeoff

  • Loungani, Prakash
  • Razin, Assaf
  • Yuen, Chi-Wa

A common feature for developing countries that have experienced a sharp drop in inflation without large output losses is the extensive use of capital controls. This study shows that capital controls significantly improve the sacrifice ratio. This element contributes to the explanation of small output losses during disinflations, in addition to the high inflation mean and large nominal output variability in the pre-stabilization phase. A useful concept for disinflation episodes is the sacrifice ratio; the percentage decline in the rate of unemployment with 1% fall in the rate of inflation. The lower this ratio the less painful is disinflation. The new classical approach, pioneered by Lucas (1973), emphasized the variability of nominal GNP growth as a main determinant of the trade-off. The argument is based on the real-nominal confusion of price and output setters, so that agents will be more likely to treat shocks as nominal when the variability of nominal GNP increases. In contrast, the new Keynesian approach, as in Ball, Mankiw and Romer (1988), emphasized the menu costs determinants of the trade-off. That is, in the presence of fixed costs of changing prices, the Phillips curve is expected to be steeper, the higher is the expected rate of inflation, since with higher expected inflation and more frequent price changes, nominal shocks will have smaller real effects.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1577.

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Date of creation: Mar 1997
Date of revision:
Handle: RePEc:cpr:ceprdp:1577
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  1. DeFina, Robert H, 1991. "International Evidence on a New Keynesian Theory of the Output-Inflation Trade-Off," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 410-22, August.
  2. Romer, David, 1993. "Openness and Inflation: Theory and Evidence," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 869-903, November.
  3. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
  4. Jeffrey D. Sachs & Andrew Warner, 1995. "Economic Reform and the Process of Global Integration," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(1, 25th A), pages 1-118.
  5. Alberro, Jose, 1981. "The Lucas hypothesis on the Phillips Curve : Further international evidence," Journal of Monetary Economics, Elsevier, vol. 7(2), pages 239-250.
  6. Leonardo Bartolini & Allan Drazen, 1996. "When Liberal Policies Reflect External Shocks, What Do We Learn?," NBER Working Papers 5727, National Bureau of Economic Research, Inc.
  7. Papell, D.H., 1988. "Expectations And Exchange Rate Dynamics After A Decade Of Floating," Papers 9, Houston - Department of Economics.
  8. Vittorio Grilli & Gian Maria Milesi-Ferretti, 1995. "Economic Effects and Structural Determinants of Capital Controls," IMF Staff Papers, Palgrave Macmillan, vol. 42(3), pages 517-551, September.
  9. Kormendi, Roger C & Meguire, Philip G, 1984. "Cross-Regime Evidence of Macroeconomic Rationality," Journal of Political Economy, University of Chicago Press, vol. 92(5), pages 875-908, October.
  10. Assaf Razin & Andrew Rose, 1992. "Business Cycle Volatility and Openness: An Exploratory Cross-Section Analysis," NBER Working Papers 4208, National Bureau of Economic Research, Inc.
  11. Davide Fiaschi, 1996. "Fiscal policies and growth," Working Papers 261, Dipartimento Scienze Economiche, Universita' di Bologna.
  12. Frenkel, Jacob & razin, assaf & Yuen, chi-wa, 1996. "Fiscal policies and growth in the world economy," MPRA Paper 22109, University Library of Munich, Germany.
  13. Beggs, John J, 1988. "Diagnostic Testing in Applied Econometrics," The Economic Record, The Economic Society of Australia, vol. 64(185), pages 81-101, June.
  14. Addison, John T. & Chappell, Henry Jr. & Castro, Alberto C., 1986. "Output-inflation tradeoffs in 34 countries," Journal of Economics and Business, Elsevier, vol. 38(4), pages 353-360, December.
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