Ambrogio Sessa Bianchi, Federico De Pace, Aidan Duggan and Alex Habris
The recent sharp rise in energy prices has pushed up the prices of energy-intensive commercial goods, with inflationary pressures subsequently extending to services in many economies. Since services are traded less and have less energy input, some have suggested that this expansion may indicate that inflationary pressures are becoming more persistent. In this post, we explore the problem from the perspective of a two-state model with a tradable sector and a non-tradable sector. They suggest that after an energy price shock: 1) the expansion of inflation from goods to services need not imply further persistent inflationary pressure or change in long-term expectations, but may reflect one-off adjustments across domestic labor markets; 2) Inflationary pressures in non-tradable sectors can have significant international repercussions.
Our flowery framework
To analyze the problem, we use a random dynamic general equilibrium model with two states linked through trade and financial linkages. We refer to countries as “home” and “foreign”, as in the economic literature.
Four main features of the model are important for our discussion. First, the countries are unequal in size, and the foreign economy is much larger and relatively more closed than the domestic economy. Second, both economies are energy importers, with energy designed as an external input into production. Third, households in both economies consume both domestically non-tradable goods (such as theatre) and tradable goods (such as theater snacks), which can either be produced locally or imported. Fourth, workers can move freely between the tradable and non-tradable sectors and have a degree of market power in setting their wages.
We model the energy shock in a simplified way by considering a global input cost shock that affects both domestic and foreign tradable sectors. We also assume that the shock is more severe on the inside than on the outside. So the shock materializes in the form of an increase in the cost of snack food inputs, which affects the local economy further.
How can an input shock in the tradable sector lead to inflation in the non-tradable sector?
To answer this question, we can focus on the impact of the shock on the external economy. Being relatively large and closed, sectoral repercussions within the foreign economy are largely unaffected by indirect effects and international developments in the domestic economy, so we can abstract from the latter.
The immediate consequences of the shock is an increase in the prices of tradable goods in the foreign economy. This is the result of companies in the tradable goods sector trying to protect their profit margins, which have contracted due to the increase in input costs.
In contrast, households in the foreign economy reduced their consumption. The demand for traded commodities decreases as a result of their now high prices. The demand for non-tradable goods falls because households prefer to consume them along with the traded goods: when the price of snacks rises and the demand for them falls, the demand for the stage also falls.
So the input cost shock is stagnant abroad.
Moving on to the labor market, this plays a major role in generating inflationary pressure in the non-trading sector. To understand why, it is important to note that higher prices of tradable goods reduce the real wages of workers in both sectors. In an effort to maintain their real incomes, workers use their market power to constrain the supply of labour, and to push nominal wages up. This process can be seen as a kind of “real wage resistance”. Most importantly, since wages are common across sectors, non-tradable firms now face higher labor costs. This is what generates higher inflation in the non-tradable sector.
Monetary policy in this context is assumed to be credible and target inflation by increasing nominal rates.
In short, we can see rising inflation in sectors not directly affected by the energy shock as a result of a common labor market and a form of “real wage resistance”. Thus, mutually reinforcing price and wage inflation need not be a sign of a loosening of inflationary expectations, which our assumption of rational expectations and reliable monetary policy precludes.
Why might inflation for non-tradable foreign goods be important to the domestic economy?
A global input cost shock generates local inflationary pressures in the tradable and non-tradable sectors of the domestic economy, through similar mechanisms as in the foreign economy.
But, unlike a foreign economy, considerations of an open economy play a major role in shaping domestic outcomes. The open economy dimension can be summed up by the bilateral real exchange rate (RER), which is determined by two separate components:
where sX And sM are the prices of domestic exports and imports to and from abroad, respectively; And 
It is useful to analyze these components and their effects on the local economy in turn.
Starting with the Domestic Binary Terms of Trade (ToT). In response to trauma, this improves (increases). Note that if we were to explicitly model the third group of commodity exporters (where the global input cost shock for snacks arises), sM It will now include energy prices and so will skyrocket, causing the total house training to deteriorate.
The bilateral ToT improvement versus the foreign economy reflects our assumption that the global input cost shock for tradable goods hurts the domestic economy more severely: prices of domestically produced snacks increase by more than those produced abroad. All else being equal, the improvement of the ToT is associated with the estimation of the domestic internal rate of return and the deterioration of the domestic trade balance: domestic consumers are turning to cheaper imported foreign snacks now.
Graph 1a simply shows the relative supply and demand for foreign traded commodities compared to domestic commodities. The larger input cost shock of domestic snacks appears here as a decrease in the relative supply of local snacks, represented by the internal shift in the relative supply schedule (from black line to green dashed line).
Chart 1a: Bilateral Terms of Trade
Graph 1b: Internal relative prices
Switch to the internal relative price ratio. As discussed by Broadbent (2017), along with ToT, there are two other relative prices that determine relative demand (and thus resource allocation) across countries and between different types of goods within each country. These are the relative prices between non-tradable goods (theatre) and tradable goods (snacks) at home and abroad, respectively.
Our assumption that the global input cost shock for tradable goods hurts the domestic economy more severely implies that the stage price for snacks falls more at home than abroad (even though all prices rise in absolute numbers). This can be seen in a simplified way in Chart 1b, which shows the supply and demand curves for non-tradable commodities relative to the tradables within an economy. The shock appears as an increase in the relative supply of theater tickets, represented by an outward shift in the relative supply schedules (from the black line to the blue dashed line for the United Kingdom; and the red dashed line for the rest of the world).
All else being equal, this movement in relative prices is associated with a decline in the RER, which helps offset the loss of competitiveness due to higher costs of tradable inputs. Domestic consumers are shifting away from tradables (domestically produced and imported) to nontradables, and do so more often than foreign consumers (point C vs. B in Graph 1b). In our example, domestic imports of snacks from abroad fall by more than foreign imports of snacks from home (i.e. domestic exports). As a result, the trade balance improves.
In short, the aggregate response to the RER is the result of two opposing mechanisms: (1) the ToT mechanism, which values the RER and leads to a deterioration in the trade balance and (2) a relative internal price effect, which lowers the value of the RER and leads to an improvement in the trade balance. In model-based simulations, the ToT effect dominates. The resulting rise helps contain inflationary pressures from the input cost shock (via lower imported inflation). However, the deterioration of the trade balance contributes to an even greater decline in domestic product.
conclusions
The global input shock leads to a global recession, widespread global inflationary pressures, and a rebound in nominal wage inflation. Therefore, monetary policy authorities face a trade-off: a more hawkish monetary policy stance to stabilize inflation at target must be weighed against shortfalls in output.
We show that price dynamics in the non-tradable sector can have important implications for RER. In the absence of the non-tradable goods sector, the RER would move one-to-one with the ToT and would therefore rise by more than in our baseline simulations. A stronger rise would mean lower imported inflation, but at the same time, a larger drop in economic activity.
Ambrogio Sessa Bianchi works in the Bank’s Global Analysis department, Federico De Pace works in the Bank’s Structural Research and Policy team, and Aidan Duggan and Alex Habris work in the Bank’s Global Analysis department.
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