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

Author/Editor: Luis Catão ; Roberto Chang
Publication Date: May 17, 2013
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate
Summary: 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.
Series: Working Paper No. 13/114
Subject(s): Commodity price fluctuations | External shocks | Producer price indexes | Terms of trade | Exchange rate appreciation | Monetary policy | Economic models

Publication Date: May 17, 2013
ISBN/ISSN: 9781484371565/1018-5941 Format: Paper
Stock No: WPIEA2013114 Pages: 64
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