The Trade-Inflation Nexus: The Role of Production Networks

From the 1990s until the COVID-19 pandemic, the world experienced a sustained period of low and stable inflation, alongside a marked increase in trade integration among countries. This paper examines the impacts of international trade on inflation through domestic production networks. We first construct a theoretical model of an open economy to illustrate how domestic input-output networks propagate the price impacts of trade shocks. Using Australia as a case study, we find that the net-work impacts of trade shocks on inflation are as significant as their direct impacts, and primarily propagate upstream, based on data of 47 manufacturing industries from 2000 to 2023. Australia’s low inflation before COVID benefited from increased exposure to China’s low-cost exports, while inflation surged during episodes of global supply chain disruptions, among other factors. This paper underscores the importance of economic globalization and production structures for inflation, and offers several implications for monetary and trade policies.