Monetary policy in a Model with Commodity and Financial Markets

This paper builds a small open economy model for a net commodity exporter to consider financial frictions and monetary policies in order to investigate the main determinants of business cycles. Since we make a distinction to the access of financial markets between the commodity and non-commodity sectors, we notice that as usual, a commodity price shock benefits the competitiveness of the economy and its borrowing terms. We outline a novel effect in this paper which we dub the “financial market effect” following a positive commodity price shock that decreases the credit premium and hence exacerbate the commodity price boom. However, the negative sectoral downturn affects entrepreneur credit together with disinflationary pressures of a real exchange rate appreciation. This opens the role for stabilization policies which we analyze comparing three types of monetary regimes. Estimating the model on South Africa, a major commodity exporting economy with inflation targeting regime, we find as conventional wisdom suggests that a hypothetical Taylor rule targeting the price-level allows for adjustment in inflation expectations that can dampen disinflationary pressures. Furthermore, due to smoother change in nominal rate of interest, there is lesser variability in financial markets.