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World Food Prices, the Terms of Trade-Real Exchange Rate Nexus, and Monetary Policy

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  • Luis Catão
  • Roberto Chang

Abstract

How should monetary policy respond to large fluctuations in world food prices? We study this question in an open economy model in which imported food has a larger weight in domestic consumption than abroad and international risk sharing can be imperfect. A key novelty is that the real exchange rate and the terms of trade can move in opposite directions in response to world food price shocks. This exacerbates the policy trade-off between stabilizing output prices vis a vis the real exchange rate, to an extent that depends on risk sharing and the price elasticity of exports. Under perfect risk sharing, targeting the headline CPI welfare-dominates targeting the PPI if the variance of food price shocks is not too small and the export price elasticity is realistically high. In such a case, however, targeting forecast CPI is a superior choice. With incomplete risk sharing, PPI targeting is clearly a winner.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 13/114.

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Length: 64
Date of creation: 17 May 2013
Date of revision:
Handle: RePEc:imf:imfwpa:13/114

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Related research

Keywords: Commodity price fluctuations; External shocks; Producer price indexes; Terms of trade; Exchange rate appreciation; Monetary policy; Economic models; price elasticity; relative price; relative prices; nominal interest rate; real interest rate; aggregate demand; monetary economics; real exchange rates; real interest rates; coefficient on inflation; export price; open economy; price stability; distribution of inflation; inflationary impact; inflation rate; inflationary pressures; inflation rates; foreign currency; domestic production; domestic consumption; price level;

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References

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  1. Angus Deaton, 1998. "Getting Prices Right: What Should Be Done?," Journal of Economic Perspectives, American Economic Association, vol. 12(1), pages 37-46, Winter.
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  13. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  14. Paul Bergin & Hyung-Cheol Shin & Ivan Tchakarov, 2005. "Does Exchange Rate Variability Matter for Welfare? A Quantitative Investigation of Stabilization Policies," Working Papers 512, University of California, Davis, Department of Economics.
  15. Luis Cat�o & Roberto Chang, 2013. "Monetary Rules for Commodity Traders," IMF Economic Review, Palgrave Macmillan, vol. 61(1), pages 52-91, April.
  16. Robert Kollmann, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," ULB Institutional Repository 2013/7630, ULB -- Universite Libre de Bruxelles.
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