Inflation dynamics in open economies: empirical evidence for G7 countries on the role of import prices and the cost channel

Abstract

The supply side effects of nominal interest rate and import prices on inflation are very important for the design of monetary policy. However, the empirical identification of the cost channel has ignored import prices. We start by developing a model which shows that ignoring import prices in the estimation of the cost channel may lead to wrong results. Taking this into account, we study the empirical relevance of the cost channel and import prices using the New Keynesian Phillips Curve (NKPC) for the G7 countries. In order to introduce import prices in the NKPC, we test several ways in which imports can affect inflation. It is assessed if imports should be treated as inputs and/or consumption goods, and also if there is immediate or slow exchange rate passthrough. Finally, besides the traditional concept of cost channel, where wages are paid in advance, it is tested whether is relevant to extend the cost channel assuming that imports of final consumption goods are also paid in advance. Empirical results indicate that the cost channel is present in imported consumption good and open economy variables play an important role in explaining inflation dynamics.