Financial Openness: Where It Matters for CPI Inflation and Where It Does Not

with Hamish McHugh-Smith (University of Canterbury)

Abstract:

This paper identifies a distinct financial channel through which openness affects inflation in a simple model of a bank and a goods-producing firm. Greater financial openness leads to lower inflation if it is cheaper for the bank to borrow abroad than at home. This hypothesis is tested on cross-section data in a sample of 75 countries over the 1973-2016 period. While there is no robust evidence for lower CPI inflation in financially more open economies in all the countries studied, we do find such an inverse link in a subsample comprising OECD countries only. By contrast, the more common measure of openness, trade openness, matters only in non-OECD countries where greater trade openness is negatively related to CPI inflation.