The Commodity Currency Puzzle

66 Pages Posted: 28 Nov 2015  

Thomas Powers

Harvard University, Students

Date Written: November 13, 2015

Abstract

Commodity-exporting countries have persistently high real interest rates and currency excess returns. To explain this fact, I adapt a classic idea: labor cost disease, or the Balassa-Samuelson effect. Commodity booms raise wages in exporter countries, and thus make local goods and services less affordable, raising the cost of living (real exchange rate). Since the real exchange rate then moves procyclically with commodity prices, it inherits a commodity risk premium that resolves the puzzle. Using a rare-disaster setup, I show that a stochastic, international business cycle model, with local labor used as a factor of production, can quantitatively match observed commodity currency risk premia. The model’s predictions about the co-movement of commodity prices and exchange rates, the cross-section of risk premia, and the dynamics of labor costs, are also consistent with the data. Finally, to understand the impact of monetary policy, I build a New Keynesian, sticky-wage extension. Policy choices (for example, a credible peg) can reduce the risk premium on the real exchange rate, but at the cost of bigger output gaps.

Keywords: Currency risk premia, commodity currency, Balassa-Samuelson, exchange rates, carry trade, commodity trade, international monetary policy

JEL Classification: F31, F41, F44, G12, G15

Suggested Citation

Powers, Thomas, The Commodity Currency Puzzle (November 13, 2015). Available at SSRN: https://ssrn.com/abstract=2694750 or http://dx.doi.org/10.2139/ssrn.2694750

Thomas Powers (Contact Author)

Harvard University, Students ( email )

Cambridge, MA
United States

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