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

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.

Keywords: Commodity price fluctuations, External shocks, Producer price indexes, Terms of trade, Exchange rate appreciation, Monetary policy, Economic models, Commodity Price Shocks, Inflation Targeting, Taylor rules, Incomplete Markets, inflation, terms of trade, monetary policy, price elasticity, relative price, inflation targeting, 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 consumpti

JEL Classification: E50, E60, F41