Monetary Policy for Commodity Booms and Busts

69 Pages Posted: 7 Oct 2019

See all articles by Thomas Drechsel

Thomas Drechsel

London School of Economics & Political Science (LSE)

Michael McLeay

Bank of England

Silvana Tenreyro

London School of Economics & Political Science (LSE) - London School of Economics

Date Written: September 2019

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 studies optimal 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 firms 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: Commodity financialization, commodity prices, Exchange Rates, monetary policy, small open economy

JEL Classification: E31, E52, E58, F41, Q02, Q30

Suggested Citation

Drechsel, Thomas and McLeay, Michael and Tenreyro, Silvana, Monetary Policy for Commodity Booms and Busts (September 2019). CEPR Discussion Paper No. DP14030, Available at SSRN: https://ssrn.com/abstract=3464575

Thomas Drechsel (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Michael McLeay

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Silvana Tenreyro

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

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