1. 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. 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. 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. 4 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 US productivity slowdown

5. 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. 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. 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. 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. 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. 10 IDB - XXVII Meeting of Latam Network of CB and FM May 9th de 2008 Desaceleración de la dda. de US

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

12. 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