Globalization and Equilibrium Inflation-Output Tradeoffs

The paper shows that capital account and trade account liberalizations affect the inefficiency of a New Keynesian open economy macro equilibrium by altering the relative weights attached to the output gap and inflation terms in the representative household's utility-based loss function. It is well known that with capital account liberalization the household is able to smooth fluctuations in consumption, while trade liberalization permits specialization in domestic production and diversification in domestic consumption. We show that an important implication of these features is that capital market and trade openness (i.e., "globalization") reduce the weight of the output gap term in the utility-based loss function. The paper provides a re-interpretation of evidence on the effect of openness on the inflation-output tradeoff, which supports the model's predictions.