Openness, Imported Commodities and the Sacrifice Ratio

Romer [1993] hypothesized that the output cost of a disinflation (the sacrifice ratio) falls with trade openness. Subsequent empirical work in many instances finds the reverse. We theorize that the sacrifice ratio increases with openness in production. When the production process is more open then changes in output lead to smaller changes in marginal costs, because costs are to a greater extent driven by exogenous factors. As a result price responses to output fluctuations are dampened and the output-inflation trade-off increases. Empirical evidence supports the hypothesis that greater imported commodity intensity in production increases the sacrifice ratio. Consistent with theory this relationship is stronger in fixed exchange rate regimes. Controlling for imported commodity intensity also leads to a finding of a significant negative impact of trade openness on the sacrifice ratio, consistent with Romer's original hypothesis.