Openness and Inflation: Theory and Evidence

Because unanticipated monetary expansion leads to real exchange rate depreciation, and because the harms of real depreciation are greater in more open economies, the benefits of unanticipated expansion are decreasing in the degree of openness. Models in which the absence of precommitment in monetary policy leads to excessive inflation therefore predict lower average inflation in more open economies. This paper tests this prediction using cross-country data. The data show a strong and robust negative link between openness and inflation.