Reference no: EM131239081

The arguments Dr. Krugman makes against the globalization hypothesis of inflation and unemployment are mostly empirical. Which argument do you find most compelling? Explain it briefly. If you do not find any of them compelling and wish to argue in favor of globalization briefly refute any two of the three arguments below.

Globalization

Recently, there has been a vocal movement in the United States which has protested against actions by the Federal Reserve to slow demand growth as the economy approaches standard estimates of the natural rate. These critics argue that the economic realities have changed and that there is no longer any risk that a rapid recovery will set off renewed inflation.

The basic argument of these critics is that globalization—the increased openness of the United States to international trade—has changed the rules of the game. Economic expansion cannot produce bottlenecks because firms can always turn to suppliers abroad. Firms will not raise prices, no matter how hot the market, because they fear competitors. And workers, constantly threatened with loss of their jobs to other nations, will not demand higher wages no matter how low the unemployment rate goes. According to this view, internationalization has either drastically lowered the natural rate or even made the whole concept irrelevant.

Many people find this argument extremely attractive. It is hard to see, however, how anyone who has looked at recent economic experience, or is familiar with basic economic data, can take the argument seriously.

First, the whole emphasis on the importance of international competition ignores the fact that both the U.S. economy and the economy of Western Europe (considered as a unit) are still primarily in the business of producing goods and services for their own use. Imports are only 11 percent of U.S. GDP. While it is true that a somewhat wider range of goods is subject to international competition than is actually traded, at least 70 percent of each economy remains effectively insulated from foreign markets—and therefore is capable of experiencing inflation regardless of international conditions.

Second, the challenge to conventional wisdom seems to take it for granted that the United States faces a perfectly elastic supply of imports at given prices in dollars. But the United States has a floating exchange rate; and any effort to promote continued recovery by keeping interest rates low would drive down the dollar and therefore raise import prices in U.S. currency. The normal view of international macroeconomists has been that an open economy with a floating exchange rate faces a steeper trade off between unemployment and inflation than a closed economy (indeed, this has been the traditional rationale for policy coordination); it is hard to see why this view should suddenly be abandoned in favor of the idea that an open economy faces no trade off at all.

Finally, there are clear recent examples demonstrating that open economies can indeed develop inflation problems if they over expand. The U.S. economy itself found inflation accelerating in the late 1980s as the unemployment rate dropped below 6 percent. Has the structure of the economy really changed so much in five years'?

But this experience pales by comparison with the British experience. The UK is a much more open economy than the United States, so if the idea that globalization prevents inflation works anywhere it should work there. But a rapid UK boom during the late 1980s produced an explosion of inflation, forcing an abrupt U-turn in the country's economic policies.

In short, there is no reason to believe that the increased openness of advanced economies has changed the basic logic of the natural rate hypothesis, or that it should lead us to modify the conclusion that a rise in the natural rate, rather than inadequate demand, is the main source of the unemployment problem in advanced economies.