Identifying determinants of the output–inflation tradeoff has been a key issue in business cycle research. We provide evidence that in countries with greater restrictions on capital mobility, a given reduction in the inflation rate is associated with a smaller loss in output. This result is shown to be consistent with the predictions of a version of the Mundell–Fleming model. Restrictions on capital mobility are measured using the IMF's Annual Report on Exchange Rate Arrangements and Exchange Restrictions. Estimates of the output–inflation tradeoff are taken from previous studies (viz., Lucas [Am. Econ. Rev. 63 (1973)] and Ball, Mankies and Romer 19 (1988)).
Understanding the determinants of the output–inflation tradeoff (or the “sacrifice ratio”) has been a key area of research in business cycle theory. The new classical approach (Lucas, 1973) and the new Keynesian approach Ball, 1994 and Ball et al., 1988 offer competing explanations for the determinants of the tradeoff. Though these studies use cross-country data to test their models, both approaches are based on closed economy considerations.
In contrast, our paper analyses the determinants of the output–inflation tradeoff in an open-economy setting. In particular, we show that countries with greater restrictions on capital mobility have smaller tradeoff parameters (i.e., steeper Phillips curves). As a prelude to the empirical results in the paper, consider the evidence in Fig. 1 below.
In the left panel, we measure the extent to which countries restrict capital movements using an index constructed from the IMF's Annual Report on Exchange Rate Arrangements and Exchange Restrictions. We have divided the sample of 35 countries used in Ball, Mankiw and Romer (henceforth, BMR) into four groups based on the average value of our capital controls index over the period 1950–1986. Group I consists of countries such as the United States and Singapore, which have had essentially no capital controls over this period, whereas countries with the most restrictions on capital mobility are in group IV. In the panel on the left, the height of the bar shows the average value (across countries) of the capital controls index for each group. In the panel on the right, the average value of BMR's estimated output–inflation tradeoff parameter for the four groups is shown. It is evident that there is an inverse relationship: the greater the intensity of capital controls, the smaller is the tradeoff parameter (i.e., the steeper is the Phillips curve). The use of Ball's sacrifice ratio estimates—instead of BMR's estimates—yields similar results.
To develop some intuition for why capital mobility might matter, consider the two polar cases of zero mobility and perfect mobility of capital, respectively. In the zero mobility case, interest rate parity does not have to hold, and this leaves more scope for adjustment in the domestic interest rate in response to shocks; at the same time, however, closed capital accounts require that net trade be balanced, and this limits the flexibility of the real exchange rate. In the perfect mobility case, the adjustment of the domestic interest rate is limited by the interest parity condition, whereas, the real exchange rate has greater room to adjust. Thus, the degree of capital mobility influences how responsive aggregate demand is to real interest rate and real exchange rate movements, and this in turn, as shown in Section 2, affects the output–inflation tradeoff. In this section of the paper, we also establish a theoretical presumption that for reasonable parameter values, an increase in restrictions on capital mobility should make the output–inflation tradeoff parameter smaller, that is, a given change in inflation rates should be associated with smaller movements in output. In Ball's terminology, the sacrifice ratio should be smaller, the greater the restrictions on capital mobility.
In Section 3, we provide empirical evidence that an index measuring the restrictiveness of capital controls is a significant determinant of the output–inflation tradeoff. The correlation holds after controlling the determinants suggested by the new classical and new Keynesian approaches, namely, the variability of aggregate demand and the expected inflation rate.
While previous studies of the determinants of the output–inflation tradeoff have been confined to a closed economy setting, our paper establishes that the degree of capital mobility is an important determinant of the tradeoff. In the present study, we used data from the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions to construct indicators of the intensity of capital controls. We found that countries with stricter capital controls had a smaller output–inflation tradeoff parameter, i.e., a steeper Phillips curve. Taken literally, an implication of this finding is that the loss in output from reducing inflation is lower in countries that impose some restrictions on capital mobility. Of course, this “gain” has to be balanced against several costs of imposing capital controls, which are not considered here.
The empirical results here are meant to be suggestive; a more refined measure of the degree of capital mobility would be needed to establish it more conclusively as a determinant of the output–inflation tradeoff. In future work, it would also be necessary to account for linkages between the choice of a monetary policy framework (which implicitly influences the output–inflation tradeoff) and the decision on whether or not to impose controls. In particular, it would be interesting to test whether countries that imposed controls already had a vertical Phillips curve.
