1 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 On Decoupling and the China Connection Pablo García Juan Pablo Medina Central Bank of Chile

2 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Motivation  Facts:  Increased trade and financial integration across regions of the world, rise of Asian giants  Sharp increase in commodity prices  Apparent decoupling of emerging economies (EME) from developed economies (DE) current credit cycle  Are these independent or related developments?  Decoupling results from differing medium term prospects between EME and DE? Or from transmission of lax monetary policy in DE to pegged EME?  Commodity prices and EME performance, cause or effect?  Can these facts result from a single shock to DE?  What role for the unwinding of global imbalances?

3 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 What we do  DSGE model of the global economy  Four economic zones: US, EU, AS, RW  Each produces differentiated traded and non traded goods  Using labor and two commodities: OIL and COPPER  RW has a commodity intensive endowment  AS is commodity intensive in production  Trade interlinkages  Standard features: price and wage rigidities, taylor rules, etc…  Model is subject to shocks  US slowdown  Monetary policy relaxation in US  Increased labor supply in AS  Weakening of the currency in AS

4 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 US productivity slowdown

5 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Results of simulations (I)  US slowndown driven by demand contraction:  Standard and expected implications on monetary policy and real exchange rates  Increase in US net exports, decrease in EU, AS, RW net exports  No decoupling: global slowdown and disinflation across the board (including commodity prices)  BUT: producer currency pricing in EU but not in AS or RW implies real impact is felt first in EU and a delayed impact in AS and RW  US slowndown driven by productivity contraction:  Some similarities on next exports dynamics  BUT significant decoupling in the short term: higher marginal costs in US, economic expansions especially in AS, rise in inflation and commodity prices across the world  Eventually, tighter monetary policies and global slowdown  AS and EU more cyclically sensitive, RW shows more stable growth dynamics

6 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Results of simulations (II)  Monetary policy relaxation in US:  Expected implications on AS, EU, RW real exchange rates and net exports  Beggar-thy-neighbour effect on regional growth, with regional subsequent disinflation  Higher commodity prices in the short run  Increased AS labor supply:  Lowers AS unit labor costs and leads to lower inflation and easier monetary policy across the board  Significant increase in commodity prices  Dutch disease in RW: appreciation leads to lower net exports and lower growth

7 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Results of simulations (III)  Monetary policy relaxation in AS:  Expected implications on US, EU, RW real exchange rates and net exports  Beggar-thy-neighbour effect on regional growth, with subsequent implications on regional disinflation  Higher commodity prices in the short run and moderate Dutch disease impact

8 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Conclusions  Can a single shock explain decoupling and global inflation?  Yes: US slowdown in productivity  Bleak medium term implications: tighter monetary policy to contain inflation across the globe  Back to the 1970’s?  However, we could be observing short term decoupling  Interaction of pricing and pegged exchange rates to the US  Good news on the inflation front  But bad news on growth prospects for AS and RW going forward  Further integration of Asia in the global economy (eg. enhanced global labor supply)  Good for global inflation  Good news with a challenge for commodity exporters

9 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 On Decoupling and the China Connection Pablo García Juan Pablo Medina Central Bank of Chile

10 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Desaceleración de la dda. de US

11 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Incremento empleo AS

12 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Comentarios finales  Herramienta complementaria para contribuir a la elaboración de escenarios de riesgo internacional