Real Exchange Rates and Commodity PricesWP/96/27-EA Real Exchange Rates and Commodity Prices by Dominique Dupont and V. Hugo Juan-Ramon Since the breakdown of the Bretton Woods system, nominal and real exchange rates between major currencies, as well as nominal and real prices of internationally traded commodities, have displayed increasing volatility. Policymakers and economists have observed that excessive variability in real commodity prices might have disruptive effects in both developing and industrial countries. In the past two decades, a number of theoretical and empirical contributions have dwelt on the phenomenon of increasing instability in commodity prices. On the theoretical side, those studies provided a link between exchange rate and commodity price fluctuations by using a standard supply-demand framework and world-market-clearing conditions; however, little attention has been placed thus far on the role of both inventory and expectations in determining commodity prices. On the empirical side, some studies analyzed the actual time-series properties of commodity prices, while others tested the fit and predictive power of reduced-form equations resulting from theoretical models. This paper formalizes a model that provides a role for expectations, flows, and stocks in determining commodity prices. The model features flow demand and supply on the part of consumers and producers, as well inventory demand on the part of speculators and producers. Speculators hold inventories to exploit expected profits, and producers hold inventories when production is high as a precaution for periods when it is low. This precautionary inventory allows producers to maintain the level of ex ante committed deliveries when production falls because of adverse shocks. The paper assumes that commodities are traded on world markets, that their prices obey the law of one price, and that the world market clears. The model is estimated by using several econometric methods on monthly data from January 1972 to January 1992 for 65 commodity prices. Short- and long-term elasticities of the U.S. dollar-deutsche mark and U.S. dollar-yen bilateral real exchange rates are estimated. The paper finds that, for a small group of commodities, the dollar-denominated price is significantly influenced by the deutsche mark and the yen. The empirical results show that geographical proximity matters, and that supply and demand elasticities are important in determining commodity prices in world markets above and beyond the size of the share of those commodities in world trade. |