Globalization, Domestic Inflation and Global Output Gaps: Evidence from the Euro Area

This paper tests whether the proposition that globalization has led to greater sensitivity of domestic inflation to the global output gap (the ‘global output gap hypothesis’) holds for the euro area. The empirical analysis uses quarterly data over the period 1979–2003. Measures of the global output gap using two different weighting schemes (based on purchasing power parities and trade data) are considered. We find limited evidence that global capacity constraints have explanatory power for domestic consumer price inflation in the euro area. Based on these findings, the prescription that central banks should specifically react to developments in global output gaps does not seem to be justified for the euro area.