International Competition and Inflation: A New Keynesian Perspective

Abstract

We develop and estimate an open economy New Keynesian Phillips curve (NKPC) in which variable demand elasticities give rise to movements in desired markups in response to changes in competitive pressure from abroad. A parametric restriction on our specification yields the standard NKPC, in which the elasticity is constant, and there is no role for foreign competition to influence domestic inflation. By comparing the unrestricted and restricted specifications, we provide evidence that foreign competition plays an important role in accounting for the behavior of inflation in the traded goods sector. Our estimates suggest that foreign competition accounted for more than half of a 4 percentage point decline in domestic goods inflation in the 1990s. Our results also provide evidence against demand curves with a constant elasticity in the context of models of monopolistic competition.

Keywords: inflation, New Keynesian Phillips curve, variable markups

JEL Classification: E31, E32, F41