Ambrogio Cesa-Bianchi, Federico Di Pace, Aydan Dogan and Alex Haberis
The recent steep rise in energy prices led to a rise in the price of energy-intensive tradable goods, with inflationary pressures subsequently broadening into services in many economies. Because services are less traded and have little energy input some have suggested this broadening might indicate inflationary pressures becoming more persistent. In this post, we explore the issue through the lens of a stylised two-country model with a tradable and a non-tradable sector. It suggests that following an energy price shock: i) the broadening of inflation from goods to services need not imply more persistent inflationary pressure or changed longer-run expectations, but may reflect one-off adjustments via domestic labour markets; and ii) Inflationary pressures in non-tradable sectors can still have sizable international spillovers.
Our stylised framework
To analyse the issue, we use a dynamic stochastic general equilibrium model with two countries that are connected through trade and financial linkages. We refer to the countries as ‘home’ and ‘foreign’, as in the economics literature.
Four key features of the model are important for our discussion. First, the countries are asymmetric in size, with the foreign economy much larger and relatively more closed than the home economy. Second, both economies are energy importers, where energy is modelled as an exogenous input into production. Third, households in both economies consume domestically produced non-tradable goods (eg theatre) and tradable goods (eg theatre snacks), which may be produced domestically or imported. Fourth, workers can move freely between the tradable and non-tradable sectors and have a degree of market power in their wage setting.
We model the energy shock in a simplified way by considering a global input cost shock that affects both home and foreign tradable sectors. We also assume that the shock is more severe at home than abroad. The shock therefore materialises as an increase in the input cost of snacks, which affects the domestic economy more.
How can an input shock in the tradable sector led to inflation in the non-tradable sector?
To answer this question, we can focus on the impact of the shock on the foreign economy. Because it is large and relatively closed, sectoral spillovers within the foreign economy are largely unaffected by international spillovers and developments in the home economy, so we can abstract from the latter.
The immediate consequences of the shock are to increase tradable goods prices in the foreign economy. This is a result of firms in the traded goods sector attempting to protect their profit margins, which have been squeezed by the increase in input costs.
In turn, households in the foreign economy cut their consumption. Demand for traded goods falls in response of their now higher prices. Demand for non-traded goods falls because households prefer to consume them alongside traded goods: when the price of snacks increases and its demand falls, demand for theatre also falls.
The input cost shock is therefore recessionary abroad.
Turning to the labour market, this plays a key role in generating inflation pressure in the non-traded sector. To understand why, it is important to note that the rise in tradable goods prices reduces the real wages of workers in both sectors. In an attempt to maintain their real incomes, workers use their market power to restrict their labour supply, pushing up on nominal wages. This process may be viewed as a kind of ‘real wage resistance’. Importantly, because wages are common across sectors, non-tradable firms now face higher labour costs. This is what generates the higher inflation in the non-tradable sector.
Monetary policy in this framework is assumed to be credible and brings inflation to target through an increase in nominal rates.
In sum, we can observe rising inflation in sectors not directly affected by the energy shock as a result of a joint labour market and a form of ‘real wage resistance’. Mutually reinforcing price and wage inflation need not, therefore, be a sign of de-anchoring of inflation expectations, which is ruled out by our assumption of rational expectations and credible monetary policy.
Why might inflation for foreign non-tradable goods matter for the domestic economy?
The global input cost shock generates domestic inflationary pressures in the tradable and non-tradable sectors in the home economy, through similar mechanisms as in the foreign economy.
But, in contrast to the foreign economy, open economy considerations play a key role in shaping domestic outcomes. The open economy dimension can be summarised by the bilateral real exchange rate (RER), which is determined by two separate components:
where PX and PM are the prices of domestic exports and imports to and from abroad, respectively; and 
It is helpful to unpack these components and their effects on the domestic economy in turn.
Starting with the domestic bilateral terms-of-trade (ToT). In response to the shock, this improves (an increase). Note that if we were to explicitly model the third block of commodities exporters (where the global input cost shock for snacks originates), PM would now include energy prices and hence rise significantly, causing a deterioration in the home aggregate ToT.
The bilateral ToT improvement vis-à-vis the foreign economy reflects our assumption that the global input cost shock for tradable goods hits the home economy more severely: prices for domestically produced snacks increase by more than those produced abroad. All else equal, the ToT improvement is associated with an appreciation of the domestic RER and a deterioration in the domestic trade balance: home consumers switch to the now cheaper imported foreign snacks.
Chart 1a shows in a stylised way the relative supply and demand for foreign traded goods relative to home traded goods. The larger input cost shock for domestic snacks shows up here as a fall in the relative supply of domestic snacks, represented by the inward shift in the relative supply schedule (from the black line to the green dashed line).
Chart 1a: Bilateral terms of trade
Chart 1b: Internal relative prices
Turning to the ratio of internal relative prices. As discussed by Broadbent (2017), alongside the ToT, two further relative prices determine relative demand (and hence the allocation of resources) across countries and between the different types of goods within each country. These are the relative prices between non-tradable (theatre) and tradable goods (snacks) at home and abroad, respectively.
Our assumption that the global input cost shock for tradable goods hits the domestic economy more severely implies that the price of theatre relative to snacks falls by more at home than abroad (although, in absolute terms, all prices are rising). This can be seen in a stylised way in Chart 1b, which shows the demand and supply curves for non-tradables relative to tradables within a particular economy. The shock shows up as an increase in the relative supply of theatre tickets, represented by the outward shift in the relative supply schedules (from the black line to the blue dashed line for the UK; and to the red dashed line for the rest of the world).
All else equal, this movement in relative prices is associated with a depreciation of the RER, which helps to compensate for the loss of competitiveness due to the higher tradable input costs. Domestic consumers shift away from tradables (both domestically produced and imported) to non-tradables, and do so more than foreign consumers (point C versus B in Chart 1b). In our example, the domestic imports of snacks from abroad fall by more than foreign imports of snacks from home (ie domestic exports). As a result, the trade balance improves.
In sum, the overall response of the RER is the result of two opposing mechanisms: (i) a ToT mechanism, which appreciates the RER and leads to a worsening in the trade balance and (ii) an internal relative price effect, which depreciates the RER and leads to an improvement in the trade balance. In our model-based simulations, the ToT effect dominates on impact. The resulting appreciation helps to contain the inflationary pressures of the input cost shock (via lower imported inflation). However, the worsening of the trade balance contributes to a bigger fall in domestic output.
Conclusions
The global input shock leads to a global recession, widespread global inflationary pressures, and a pickup in nominal wage inflation. Monetary policy authorities, therefore, face a trade-off: a tighter monetary policy stance to stabilise inflation at target needs to be balanced against a shortfall in output.
We show that price dynamics in the non-tradable sector can have important implications for the RER. In the absence of the non-tradable goods sector, the RER would move one-to-one with the ToT, and hence would appreciate by more than in our baseline simulations. A stronger appreciation would imply lower imported inflation but, at the same time, a larger fall in economic activity.
Ambrogio Cesa-Bianchi works in the Bank’s Global Analysis Division, Federico Di Pace works in the Bank’s Research and Structural Policy Team, Aydan Dogan and Alex Haberis work in the Bank’s Global Analysis Division.
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