Globalization, Inflation and Currency Pegs

In recent years headline inflation rates around the world have accelerated mainly due to double-digit increases in food and energy prices. On the other hand, core inflation, which excludes food and energy prices, has remained more or less stable. See The Economist.

The divergence in the headline and core inflation represents a terms-of-trade improvement for commodity-exporting countries, especially oil-exporters.

If globalization, and the accompanying expansion of trade between developed and developing countries, had contributed to the moderation of global inflation in the1990s and early 2000s, then it is also part of the equation in the recent surge of inflation around the world. There is a demand-pull aspect to the story, especially as developing countries' continued growth has driven the demands and prices for resources higher. On the other hand, the surge in inflation in the US comes at a time when its economy is facing a recession. Thus the possibility of a stagflation--a name for the uncomfortable combination of an economic slow down and higher inflation.

Countries who peg their currencies to the US dollar (such as the Gulf states) will be affected by higher US inflation and the declining exchange rate of dollar, since the peg forces their monetary policymakers to cut interest rates and expand domestic money supplies. Thats why, in a move to combat the inflationary effects of a weaker dollar, Kuwait has recently ended its dollar peg. However, for many least developed countries, including Eritrea, whose inflation rates are higher than that in the US, ending their dollar pegs would not help solve their problems.