Monetary Policy Under Commodity Price Fluctuations

• Published date: 01 May 2015
• Author: Roberto Chang
• Date: 01 May 2015
• DOI: http://doi.org/10.1111/rode.12142

Monetary Policy Under Commodity Price

Fluctuations

Roberto Chang*

Abstract

This paper discusses monetary policy in a New Keynesian open economy subject to commodity price fluc-

tuations. We review theoretical results that imply that stabilizing the producer price index (PPI) is optimal

only under special circumstances. In a calibrated version of the model, PPI targeting is compared against a

policy that stabilizes a forecast of the consumer price index. The results depend on model specifics, espe-

cially elasticities of substitution and the structure of international asset markets.

1. Introduction

One of the most notable developments since the mid 2000s has been a generalized

increase and exacerbated uncertainty in the world prices of commodities, including oil,

metals, and food. This has posed a difficult dilemma to central banks, especially those

that have adopted the targeting of a headline price index (such as the consumer price

index (CPI)) as the fulcrum of monetary policy. Indeed, countries that import food, oil,

and other basic commodities have faced the unpleasant dilemma of whether or not to

apply monetary brakes to offset inflationary pressures derived from increasing com-

modity prices. For exporters of commodities, a main issue has been whether to relax

monetary policy to prevent exchange rate appreciation resulting from price windfalls.

This paper discusses the above issues in the context of dynamic stochastic model of

a small economy. The model is taken from Catão and Chang (2013) and is representa-

tive of state of the art New Keynesian models discussed at length in Woodford (2003)

and Galí (2008). The application to the small economy extends Galí and Monacelli

(2005), De Paoli (2009), and others in allowing world commodity prices to fluctuate.

In addition, the model is general enough to accommodate a number of features of

interest, such as an export enclave sector of the kind often seen in Latin America or

imperfections in international financial markets.

The model illustrates, in particular, an ongoing and active debate on the applicabil-

ity to open economies of monetary prescriptions derived for closed economies. Fol-

lowing Woodford (2003), studies of New Keynesian models of closed economies often

find that it is optimal for a central bank to stabilize an index of producer prices.

Under some restrictions on parameters and model features, Galí and Monacelli

(2005) showed that the result could be extended to an open economy as well. These

findings may suggest that a small economy would be well served by adopting an infla-

tion targeting regime, but one in which the target is not the CPI but the producer

* Chang: Department of Economics, Rutgers University, 75 Hamilton Street, New Brunswick, NJ 08901,

USA. Tel: +1-848-932-7269; E-mail: chang@econ.rutgers.edu. I am heavily indebted to Luis Catão for

allowing me to draw heavily on our joint work. I also received useful comments from an anonymous

referee, Rodolfo Cermeño, and participants at the 2013 DEGIT conference. This paper was prepared for

the 2013 Latin American Reserves Fund (FLAR) Conference. FLAR’s financial support is acknowledged

with thanks. Of course, I am solely responsible for the views expressed here and any errors or omissions.

Review of Development Economics, 19(2), 282–296, 2015

DOI:10.1111/rode.12142

© 2015 John Wiley & Sons Ltd