Real Exchange Rates and Commodity Prices


WP/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.