We embed the canonical rational expectations competitive storage model into a general equilibrium framework thereby allowing the non-linear commodity price dynamics implied by the competitive storage model to interact with the broader macroeconomy. Our main result is that the endogenous movement in interest rates implied under general equilibrium enhances the effects of competitive storage on commodity prices. Compared to a model in which the real interest rate is fixed, we find that storage in general equilibrium leads to more persistence in commodity prices and somewhat lower volatility. Moreover, the frequency of stockouts is lower in general equilibrium. A key mechanism driving this result is a link between the ability of the household to smooth consumption over time and the level of storage in the stochastic equilibrium. Finally, the model is used to examine the macroeconomic effects of both biofuel subsidies for ethanol producers and, seperately, subsidies designed to insulate households from high food prices.

We study monetary policy rules for open economies with different export-import structures and imported inputs in production, under alternative assumptions on international risk sharing. We describe, in particular, how the dynamic responses to alternative shocks and the welfare implications of monetary rules interact with imperfections in financial markets. For most parameterizations, PPI targeting rule emerges as slightly superior to CPI targeting, and considerably better than expected CPI targeting and an export price targeting rule. Imperfect risk sharing is noticeably welfare decreasing and calls for a more aggressive response to inflation.

The recent volatility in global commodity prices and in the price of oil, in particular, has created renewed interest in the question of how monetary policy makers should respond to oil price fluctuations. In this paper, we discuss why this question is ill-posed and has no general answer. The central message of our analysis is that the best central bank policy response to oil price fluctuations depends on why the price of crude oil has changed. For example, an unexpected oil supply disruption in the Middle East calls for a different policy response than an unexpected increase in Chinese productivity or oil intensity. This means that policy makers need to disentangle the structural shocks that are jointly driving the price of oil and the macroeconomy and tailor their response to the observed mix of shocks. We use a multi-country DSGE model to quantify the appropriate policy responses and to analyze the optimal responses from a welfare point of view. We also reexamine the welfare gains from global monetary policy coordination in a world with trade in oil.

We analyze optimal policy in a simple small open economy model with price setting frictions. In particular, we study the optimal response of the nominal exchange rate following a terms of trade shock. We depart from the New Keynesian literature in that we explicitly model internationally traded commodities as intermediate inputs in the production of local final goods and assume that the small open economy takes this price as given. This modification is not only in line with the long standing tradition of small open economy models, but also drastically changes the optimal movements in the exchange rate. In contrast with the recent Small Open Economy New Keynesian literature, our model is able to reproduce the commovemt between the nominal exchange rate and the price of exports, as it has been documented in the commodity currencies literature. In our model, in contrast with existing results, price stability is not optimal, unless fiscal policy (taxes) can move with shocks independently of preferences. Our model justifies fear of floating.

In this paper, we present a dynamic general equilibrium model for an oil-importing small open economy in order to assess the business cycle implications of oil price shocks. Our analysis reveals important findings about how shocks to the level and volatility of oil prices affect the economic activity and how these effects change with the degree of financial integration. While investment and output can increase in response to higher volatility in the case of financial autarky, where households can use only physical capital for precautionary savings, the availability of internationally traded bonds as an extra asset can overturn this counterfactual result. Moreover, our results suggest that the coexistence of level and volatility shocks can serve as a mechanism to generate asymmetric effects of oil price increases and decreases as seen in the data.

Intergenerational funds smooth expected consumption across generations in face of an oil windfall. Precautionary buffers or liquidity funds cope with oil price volatility and are a politically more acceptable alternative to hedging. The magnitude of these buffers depends on the volatility of oil prices, the degree of prudence, intergenerational inequality aversion and the GDP share of oil rents. For a net creditor, asset return uncertainty depresses saving unless prudence is large and risk aversion small. For a net debtor, oil price and asset return uncertainty always depress borrowing below what is necessary for consumption smoothing. Uncertain returns on domestic investment offers an alternative explanation why capital scarce, developing countries are big savers and small investors. Allowing for infinite horizons, our ballpark estimate of the optimal liquidity buffer for Ghana is very small relative to its intergenerational fund of 24 billion USD even for very high degrees of prudence, for Norway our rough estimate of the optimal liquidity fund is 156 billion USD (given relative prudence of 3) compared with 1.39 trillion USD for the intergenerational fund. Iraq should build an intergenerational fund of 2.81 trillion USD; even for a very low coefficient of relative prudence (1.025) it accumulates an extra massive liquidity fund of 1.92 trillion USD. Given capital scarcity and inefficient adjustment of public capital, we argue that Ghana should be concerned about using its windfall for investment rather than hedging against oil price volatility.

Natural resource revenues provide a valuable source to finance public investment in low-income countries. Conventional wisdom, however, advises to save most windfalls abroad to preserve wealth. We develop a dynamic stochastic general equilibrium model to study the tradeoffs between saving resource revenues abroad in a sovereign wealth fund and investing them domestically in public capital. Public investment may be highly desirable in capital-scarce countries, but several concerns are present, including Dutch disease, growth sustainability, absorptive capacity constraints, and risks to macroeconomic stability. By scaling up investment gradually and securing funding for recurrent capital costs, we show that this investing approach can address those concerns, preserve resource wealth and contribute to economic development.

Introduction

The inflationary consequences of rising commodity prices represent an important challenge for monetary policy. Rising commodity prices result in an increase in inflation, but at the same time have negative consequences on economic activity. Their implications for monetary policy are less straightforward than those of demand shocks. For example, a positive demand shock that increase inflation and output calls for monetary tightening in order to stabilize both. However, the implications of commodity price shocks are less clear cut.

For the purpose of the discussion in this paper I will consider an economy that is a net importer of commodities, and local demand for the commodity is relevant. This commodity may be an intermediate input, such as oil, or a final good, such as gasoline or food. Therefore, a commodity price shock is an inflation shock and has negative effects on income at the same time. I will not focus on natural resource abundant economies, where the rise of commodity prices represents mainly a positive wealth effect, in particular when the fraction of the production of the commodity consumed at home is small.

Let us consider, for example, the case of oil. Inflation rises through the direct effects on gasoline prices and indirectly through a rise in costs. In addition, an oil price shock is analogous to a negative productivity shock. Therefore inflation rises and output slowdown. Although in principle one could think that the implications on monetary policy are ambiguous, they are not. Some degree of accommodation may be needed, and this depends on the output effects and the duration of the shock, but the direction of monetary policy is to reduce the monetary impulse.

The inflationary effect of an oil price shock requires a tightening of monetary policy. The effect on activity also needs tightening, since the effects on output are mostly a fall in full-employment output, since the energy shock is equivalent to a negative productivity shock, and hence the output gap increases, inducing further inflationary pressures. There are some caveats to this conclusion. As I discussed later on, there are mitigating demand effects, which could be very important in the case of a food prices shock, since the commodity prices may result in a decline in the terms of trade and national income. In addition, a credible inflation targeting regime may need a much smaller response when facing transitory supply shocks, and indeed as I document in this paper, the fact that the recent oil shocks have had small effects on inflation and activity hinge to a large extent on the conduct of monetary policy geared toward price stability.

The recent experience with commodity price shocks has been very significant. Since the mid 2000s all commodity prices started rising sharply (figure 1). The initial reaction in policy and academic circles was how to react to a transitory commodity price shock. In this case, there were good reasons to think that a short-lived price shock should not require decisive policy reaction. However, reality turned out to be quite different. Commodity prices kept rising to unprecedented levels and the change was much more persistent. Only at the peak of the subprime crisis, late 2008, commodity prices suffer a major reversal, but even in a world that has not fully recovered from the crisis, commodity prices rose again.

The magnitude and persistence of high commodity prices were not expected some years ago, and hence, it is not appropriate to conduct monetary policy under the assumption that the shock is temporary. Today is better to work with the assumption that there has been a persistent change in the relative price of commodities. Economies must adjust to these new relative prices, but during the adjustment monetary policy must avoid increases in inflation that may end up being too costly to revert. Excessive propagation feeds back into prices through indexation and rising inflationary expectations.

These two commodity price booms have resulted in higher inflation, and the purpose of this paper is to analyze some relevant issues from the point of views of monetary policy. For analytical purposes I will define two commodity price booms, one from the third quarter of 2006 to the third quarter of 2008, and the other from the third quarter of 2009 to the third quarter of 2011. The reason to define the episodes this way was to have equally sized episodes (2 years), which should facilitate comparisons.

The commodity price shocks resulted in an increase in food and energy inflation. They are mechanically passed into headline inflation. The magnitude of these effects depends on the weight of each component on the CPI. But in addition, there are the so-called second round effects, which refer to the indirect impact on other prices, through cost or demand pressures. Figures 3 and 4 show the correlation between food and energy inflation with headline and core inflation for a sample of 34 countries in both episodes. It is interesting to note that in most countries there was a relevant increase in food and energy inflation, which varies across countries and episodes. The simple correlation shows that the rise in food and energy prices had an effect on headline inflation.

The increase in food prices also had important second round effects, which, as the figures show, are already affecting core inflation two quarters after the shock started. The second round effects of energy are weaker, in particular during the second episode. This is consistent with the evidence discussed later on the relevance of food vis-à-vis energy in the propagation of inflation.

The paper follows in two main sections. Section 2 is devoted to an analytical discussion on commodity prices and monetary policy. In the first part I take on the issue of whether the target inflation should be done in terms of core or headline inflation, and regardless the target, how monetary policy must react to rising core and headline inflation. Despite core inflation is a better measure of underlying inflationary pressures, setting up the target in terms of headline inflation is desirable and it is the usual practice of central banks. In addition, ignoring the developments of headline inflation may lead to an underestimation of future inflation when hit by long-lasting commodity price shocks. Then, I present a very simplified model to discuss the channels through which commodity prices affect the economy and its implications on monetary policy. I distinguished the direct impact on inflation, and the impacts on full-employment output and aggregate demand.

In section 3 the paper looks at the empirical evidence of the two episodes of commodity price booms. It reviews the literature on second round effects and propagation, and present new evidence on the relevance of food and energy in the propagation of inflation. The evidence shows that energy has very limited second round effects, while those of food are much more important. The paper concludes in section 5 with some final remarks.

We explore the linkage between equity and commodity markets, focusing in particular on its evolution over time. An important debate in the literature concerns whether the large fluctuations in commodity prices in the late 2000s can be attributed to less segmentation of commodity markets. We document that a country’s equity market value has significant out-of-sample predictive ability for the future global commodity price index for several primary commodity-exporting countries. We find, however, little evidence of in-sample predictive ability, even after allowing for instabilities. The out-of-sample predictive ability of the equity market appears towards the middle of the 2000s, thus suggesting a decrease in market segmentation and the possibility that shocks in equity markets might have started to spill-over onto commodity markets in that period. The results are robust to using country-specific commodity indices as well as firm-level equity data. Finally, our results indicate that exchange rates are a better predictor of commodity prices than equity markets. We show, however, that this is not the case for non-commodity currencies, as intuition would suggest.

We assess whether and to what extent financial activity in the oil futures markets has contributed to destabilize oil prices in recent years. We de.ne a destabilizing financial shock as a shift in oil prices that is not related to current and expected fundamentals, and thereby distorts efficient pricing in the oil market. Using a structural VAR model identified with sign restrictions, we disentangle this non-fundamental financial shock from fundamental shocks to oil supply and demand to determine their relative importance. We find that shocks to oil demand and supply remain the main drivers of oil price swings. Financial investors in the futures market can however destabilize oil spot prices, although only in the short run. Moreover, financial activity appears to have exacerbated gyrations in the oil market over the past decade, particularly in 2007-2009.

Kilian (2009a) makes the case that there are three main sources of oil price fluctuations: oil supply shocks, global aggregate demand shocks and precautionary or speculative demand shocks. He empirically documents the distinct effects of these shocks on the global economy. Using an estimated DSGE model for the U.S. economy, we show that similar results can be obtained. Incorporating (speculative) competitive oil storage to the model enables us to formally analyze the impact of the speculative oil demand shock, and also to assess how the effects of various demand and supply shocks change in the presence of oil storage facility. We .nd that productivity shocks were the most important drivers of oil price fluctuations during 1982-2007, but speculative demand shocks played a role as well. Moreover, disregarding storage facility in the model causes a considerable upward bias in the estimated role of oil supply shocks in driving oil price fluctuations. We also find that change in the composition of shocks can help explain the resilience of macroeconomic environment to oil price hikes in 2000s. Finally, speculative storage is shown to have a mitigating or amplifying role depending on the nature of the shock.

Recent swings in commodity prices have brought the implications of their impact on domestic prices and the appropriate policy response to the forefront. Moreover, these large shocks can potentially serve as event studies to assess the empirical performance of different types of monetary and exchange rate regimes, such as inflation targeting. Is there a relation between differences in policy frameworks and the transmission of international price shocks to domestic headline and core inflation? To date, surprisingly little systematic research has been conducted on this issue. One attempt can be found in the IMF’s World Economic Outlook (IMF, 2011) which examines the impact of commodities prices on inflation in a broad set of countries. However, the analysis stops at assessing that “commodity prices tend to have stronger and longer-lasting effects on inflation in economies with high food shares in the consumption basket and in economies with less firmly anchored expectations.”

Here, we go further in various dimensions. We examine questions such as: Did countries with more independent central banks or inflation-targeting regimes experience lower passthroughs and spillovers to core inflation? What is the role of the openness of the economy and the development of its financial sector in the transmission of international price shocks? How important is the pre-existing level of inflation in determining the pass-through? Are weaker fiscal positions associated with less anchored inflation expectations? To which extent does a country’s governance framework – beyond the institutional features of the monetary regime - matter in containing the impact on inflation? What role does exchange-rate flexibility play? We examine these questions in a comprehensive way using data from both developing and advance economies over the period 1990-2010.

First we assess the speed at which headline inflation reverts to core Inflation and relate these adjustment speeds to country characteristics and policy frameworks. Next, we estimate passthroughs of international food and fuel prices to domestic inflation using both country by country estimations and panel estimations of augmented Phillips curves, relating the size of the pass-throughs to country variables. Finally, we study the cross-country performance of headline and core inflation around the large 2008 food price shock. One methodological innovation is that we explicitly examine the role of the dispersion of survey forecasts (as a measure of uncertainty about monetary policy.)

To some extent, the results are surprising. In line with conventional wisdom, we find that commodity price shocks have stronger and longer-lasting effects on domestic inflation in developing countries than in advanced economies. Moreover, there is evidence that more open economies and those with higher food shares in CPI experienced a stronger inflation impact. However, while we find some evidence that inflation targeting countries fared better in their inflation response to shocks, the effect is modest and not evident around the large 2008 food price shock.

In particular, the data suggest that around that episode, inflation targeters were not more able than other countries to prevent a pass-through of commodity price shocks to core inflation, even when controlling for other factors. However, this does not mean that monetary policy credibility does not matter: to some extent, countries with more independent central banks appear to have been able to anchor expectations, and countries with higher governance and regulatory framework scores – proxies for policy credibility – also seem to have managed to contain the impact of these shocks better. Neither debt concerns nor labor market flexibility appear to significantly influence the way to which domestic inflation responds to international price shocks.

Booms in commodity prices imply significant challenges for macroeconomic policy in commodity-producing nations. Fluctuations in commodity prices are often associated with macroeconomic volatility. Using a small open economy real business cycle model, Mendoza (1995) estimates that roughly one-half of the variation in aggregate output in a sample of the G7 and 23 developing economies can be attributed to terms of trade shocks. Kose (2002) applies a similar framework and finds that terms of trade shocks can explain almost all of the variance in output in small open developing economies.

But in this regard not all nations are created equal. The macro response to commodity booms and busts depends both on the structural characteristics of the economy and the policy framework that is in place. In this paper we investigate the response of a group of commodity-producing nations in episodes of large commodity prices booms. We center our analysis on the response of output and the real exchange rate to commodity price shocks controlling by the role played by the financial market depth, the exchange rate regime and other usual controls using in the literature.

Commodity price shocks are transmitted to the economy through different channels. One of them is fiscal policy. In Céspedes and Velasco (2011) we revisited the issue of fiscal procyclicality in commodity republics, i.e. countries for which commodity-linked revenues represent a large portion of government revenue. Given that the behavior of commodity prices is plausibly a main driver of fiscal policy outcomes in these countries, we focused on the behavior of fiscal variables across the commodity cycle.

But fiscal policy is not the only factor that matters. There other channels through which terms of trade shocks (or shocks to commodity prices) affect the macroeconomic performance of a country. The theoretical and empirical literature has stressed the role played by exchange rate regime in the transmission of terms of trade shocks to the economy. Under a fixed exchange rate regime, the domestic currency is pegged to another currency or to a basket of currencies while under a flexible exchange rate regime the nominal exchange rate is allowed to move freely in response to supply and demand conditions in the foreign exchange market. In the presence of nominal rigidities, a flexible exchange rate regime helps stabilize the economy in response to terms of trade shocks as the nominal exchange rate adjusts immediately to the real shock. The alternative is to wait until nominal wages and goods’ prices adjust, increasing the volatility of output and employment.

The empirical evidence tends to support the view that more flexible exchange rate regimes tends to insulate the economy better when facing terms of trade shocks. Broda (2002), using a sample of developing countries, documents that in response to negative terms of trade shocks countries with fixed exchange regimes experience large and significant declines in real GDP and the real exchange rate depreciates slowly. The opposite occurs in the case of flexible exchange rate regimes. Edwards and Levy Yeyati (2003) find evidence that indicate that terms of trade shocks are amplified in countries that have more rigid exchange rate regimes. They also provide evidence of an asymmetric response to terms of trade shocks. In particular, they find that the output response is larger for negative than for positive shocks.

Finally, Aghion et al (2008) provide evidence that the impact on productivity growth of terms of trade shocks also depends on the nature of the exchange rate regime. They show that their impact is larger under a fixed exchange rate regime and close to zero under a flexible rates regime. In this paper we characterize the response of different macroeconomic variables in the episodes of high commodity prices documented in Céspedes and Velasco (2011). First we review the different channels through which shocks to commodity prices affect the domestic economy using a simple open economy model with nominal rigidities and financial frictions. We provide a closed form solution for the output response to a commodity price shock as a function of the degree of exchange rate flexibility and of financial market depth. As expected, the output response is smaller for more flexible exchange rate regimes. We also show that the output response to commodity price shocks goes up as financial development rises from a low level, but it eventually goes down as financial development becomes sufficiently high.

Next, we provide empirical evidence regarding the role played by the exchange rate regime, the development of financial markets, international reserve accumulation and the degree of openness in the transmission of commodity price shocks. We concentrate our analysis on the output dynamics and the evolution of the real exchange rate in those episodes of large commodity prices. We find that, consistent with the theoretical predictions, more flexible exchange rate regimes are associated with smaller responses of output to commodity price shocks. We also provide evidence that the impact of those shocks tends to be larger for economies with financial markets of intermediate levels of development.

Finally, we provide evidence that the response of the real exchange rate to commodity price shocks is larger for more flexible exchange rate regimes. We also find that the rate of international reserve accumulation tends to reduce the appreciation of the real exchange rate in episodes of commodity price booms. At a first glance, this last result may be explained by the fact that less flexible exchange rate regime must accumulate international reserves in order to keep the parity. Nonetheless, when we control for the flexibility of the exchange rate regime, the results hold.

The paper is organized as follows. In the next section we construct a simple model that captures the role of financial constraints, nominal rigidities and the exchange rate regime in the transmission of commodity price shocks. Then we turn to the empirical analysis. We first specify the commodity price indexes used in the analysis and lay out the precise definition of a boom. Then we present regression analysis on the determinants of output and exchange rate dynamics in our commodity boom episodes. A final section offers some preliminary conclusions.