Working Paper: CEPR ID: DP14030
Authors: Thomas Drechsel; Michael McLeay; Silvana Tenreyro
Abstract: Macroeconomic volatility in commodity-exporting economies is closely tied to fluctuations in international commodity prices. Commodity booms improve exporters' terms of trade and loosen their borrowing conditions, while busts lead to the reverse. This paper studiesoptimal monetary policy for commodity exporters in a small open economy framework that includes a key role for financial conditions. We incorporate the interaction between the commodity and financial cycles via a working capital constraint for commodity producers, which loosens as commodity prices increase. A rise in global commodity prices causes an inefficient reallocation towards the commodity sector, which expands and increases its demand for inputs. The real exchange-rate appreciates, but because domestic fims do not internalize that the appreciation reduces the scale of the reallocation, they do not raise prices enough. An inefficient boom takes place, with inflation rising and output increasing relative to its welfare-maximizing level. Returning inflation to target is not sufficient to close the output gap, leaving the policymaker facing a stabilization tradeoff. The optimal policy lets the exchange rate appreciate and raises interest rates, with a larger rate rise required the greater the loosening in borrowing conditions. The paper compares alternative policy rules and discusses a key practical challenge for emerging and developing economies: how to transition to a stable path from initial conditions of high and persistent inflation.
Keywords: monetary policy; small open economy; commodity prices; exchange rates; commodity financialization
JEL Codes: E31; E52; E58; F41; Q02; Q30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Global commodity prices rise (Q02) | Inefficient reallocation of resources towards the commodity sector (Q02) |
| Inefficient reallocation of resources towards the commodity sector (Q02) | Increased demand for domestic goods and inputs (J23) |
| Increased demand for domestic goods and inputs (J23) | Appreciation of the real exchange rate (F31) |
| Appreciation of the real exchange rate (F31) | Domestic firms under-adjust their prices (L11) |
| Domestic firms under-adjust their prices (L11) | Inflationary environment (E31) |
| Inflationary environment (E31) | Output level above the welfare-maximizing level (D69) |
| Global commodity prices rise (Q02) | Inflationary environment (E31) |
| Global commodity prices rise (Q02) | Output level above the welfare-maximizing level (D69) |
| Returning inflation to target alone (E31) | Insufficient to close the output gap (E62) |
| Optimal policy response (allow exchange rate to appreciate and raise interest rates) (E63) | Stabilization of the economy (E63) |
| Larger increase in borrowing conditions (F65) | Greater necessary rate rise (E43) |