Monetary policy responses to food price volatility

Monetary Policy Responses to

Food and Fuel Price Volatility

Eswar Prasad

Presentation draws on:



Joint work with Rahul Anand (IMF):

“Optimal Price Indices for Targeting

Inflation under Incomplete Markets”, NBER

Working Paper No. 16290



“Rethinking Central Banking”:

Sept. 2011 Report of Committee on

Motivation



Low and stable inflation is a key objective of

monetary policy



Choosing appropriate price index important

operational issue in implementing any version

of monetary policy



Operational issues I do not look at include:



Level of inflation target



Point vs. band target

Related literature

 Targeting core (excl. food and energy prices) is optimal  It is a suitable measure of inflation (Wynne, 1999)  Food and energy shocks are supply shocks, so no

monetary intervention is required (Mishkin, 2007,2008)

 Theoretical Basis

 Goodfriend and King (1997)  Aoki (2001)

 Major assumption - complete markets

But...



Markets are far from complete



Consumers are credit constrained



Unable to smooth consumption over time



Campbell and Mankiw (1989, 1990, 1991);

Share of population with access to

formal finance

Emerging Markets Percent with access Advanced Economies Percent with access Argentina 28 Belgium 97 Brazil 43 Canada 96 Chile 60 Denmark 99 China 42 France 96 Egypt 41 Germany 97 India 48 Italy 75 Indonesia 40 Netherlands 100 Iran 31 Spain 95 Korea 63 Sweden 99 Malaysia 60 Switzerland 88

Mexico 25 United Kingdom 91

South Africa 46 United States 91

Objective of this paper



Analytically determine the appropriate price

index for markets with financial frictions in

general and emerging markets in particular



Choices limited to practical operating rules for

monetary policy—objective is not to find

optimal rule or optimal price index

Financial frictions imply...



Idiosyncratic shocks matter for

consumption choice



Income and expenditure of households

depend on



Composition of household expenditure



Price elasticity of demand for goods

High share of expenditure on food in

household expenditure in EMs

Emer gi ng M ar kets

Advanced Economies

Indonesia 53.0 Japa n 14.7 Vie tnam 49.8 Germany 11.5 India 48.8 Australia 10.8 China 36.7 Canada 9.3 Russia 33.2 United Kingdom 8.8 Malaysia 28.0 USA 5.7

Price elasticity of demand for food is low

A L B A T G A RG A R M A U S AU T A Z E B H S B HR B G D B R B B L R B EL B L Z B E N B M U B O L B W A B R A B G R CM R C AN CH L Z AR C IV CZ E DN K DM A EC U E G Y E S T F JI F IN F RA G A B G E O DE U G R C G R D G IN H KG H U N IDN IR N IR L IS R J A M J P N J O R K A Z K E N KO R K G Z L V AL T U LB N L UX M K D M D G M W I M L I M US M E X M D A M N G M A R N P L NL D N Z L N G A N O R OM N P A K P R Y P E R P H L PO L P R T R O M RU S S E N S L E S G P S VK S V N E S P LK A K N A L CA S W Z S W E CH E S Y R T JK T HA T T O T U N T U R T K M UK R GB R U S A U RY UZ B V E N V N M Y E M Z M B Z W E -. 4 -. 3 -. 2 -. 1 C o m p e n s a te d o w n p ri c e e la s tic ity o f fo o d 4 6 8 1 0 1 2

We develop a model incorporating these features:



Incomplete markets – “rule of thumb consumers”



Subsistence level food consumption



Low elasticity of substitution for food



Share of expenditure on food in total household

expenditure high

Contributions



Analytically determine choice of appropriate price

index in an economy with financial frictions



More realistic modeling of emerging market

economies



Results more generally applicable to economies

Model



Two sector, two good closed economy new

Keynesian model



Sectors

 Flexible price sector (food)  Sticky price sector (non food)



Goods

 one type of flexible price good ( )

 continuum of monopolistically produced sticky price goods

F C ) 1 , 0 ( in indexed ) (

z

z

Î

c

 1+λ Continuum of infinitely lived households

 Heterogeneous in terms of borrowing opportunities  No storage technology or investment

 λ fraction face liquidity constraint: consume their wage

income every period

 Others are free to borrow

 Each household owns a firm and produces one good



Households, indexed by i, maximize the

discounted stream of utility



u(.) represents the utility of the form

)] , ( [ 0 0 i t i t t t N C U E

å

¥ = b y f s y s + -= - + 1 ) ( 1 ) ( ) , ( 1 1 i t n i t i t i t N C N C U

(

)

_h

(

)

_h h h h g g 1 1 1 1 1 , 1 1 1 * , 1 ) ( 1 - -úû ù êë é _{- +} -= i t s i t f i t C C C C 1 1 0 1 , ( ) -ú û ù ê ë é =

ò

q q q q z c C_si _{t t}i



Constrained households maximize subject to



Unconstrained households maximize subject to

* , C P N W C P_{t t}f = _t f _tf - _{f t} * , 1 1 1 0 1 0 ) ( ) ( ) (z N z dz z dz R B P C W B C P_{t t}s + _t =

ò

_ts _ts +

ò

P_t + _{t- t-} - _{f t}

Production



Firms in flexible price sector

 Produce food using linear technology

 Shock same across all household

 Linear technology and flexible prices imply

s y f ÷ø -ö ç è æ = ) ( , , , , f t t f t f t f n t t f C A A y P P f t t f t f A N y _, = _,



Firms in sticky price sector

 Produce non-food goods using linear technology

Where is a sticky price good and

is the labor used in the firm producing good indexed by z.

 Shocks are same across the households

 Calvo (1983) staggered price setting



Markets clear

) (z y_t ) ( ) (z A_, N z y_t = _{st t}s ) (z N_ts



Monetary policy rule (Taylor rule)



Flexible price sector shock



Sticky price sector shock

)

/

log(

)

/

log(

)

/

log(

)

/

log(

₁

-+

P

P

+

=

R

R

Y

Y

R

R

_t

r

_{i t}

r

_{p t}

r

_{y t} ) , 0 ( . . , , 1 ,t af f t t t a,f f A i i d A ₊ =

r

+

x

x

»

s

) , 0 ( . . , _, , 1 ,t as st t t a s s A i i d A ₊ =

r

+

u

u

»

s

Model analysis



Second order approximation of welfare

 around steady state

 Conditional welfare  Total welfare s f i N C U E V _ti _{j t}i _j j j t i t ( , ) for , 0 = º ¥ _{+ +} =

å

b s t f t total

V

V

V

=

l

*

+

Two market specifications



Complete financial markets

Policy regimes

 Strict core inflation targeting

 Strict headline inflation targeting

 Flexible core inflation targeting

 Flexible headline inflation targeting

) / log( ) / log( ) / log( _ , _ 1 _ s t s t i t R R R R = r _- + r_p P P ) / log( ) / log( ) / log( _ _ 1 _ P P + = _{i t- t} t R R R R r r_p ) / log( ) / log( ) / log( ) / log( _ _ , _ 1 _ Y Y R R R R_t = r_{i t-} + r_p P_{s t} Ps + r_{y t} ) / log( ) / log( ) / log( ) / log( _ _ _ 1 _ Y Y R R R R_t = r_{i t-} + r_p P_t P + r_{y t}

Calculating welfare gains

 Welfare under strict core inflation targeting as baseline

 Welfare cost, , is defined as consumption needed to

make consumers as well off under strict core inflation targeting as under regime a

 Positive number indicates welfare is higher under

regime a

 gives the percentage of life time consumption

) , ) 1 (( 0 0 0 r t r t c t t a N C U E V =

å

b +w ¥ = c

w

100

*

c

w

Results: Welfare cost of targeting different

price indices

Complete Markets Incomplete Markets

Strict Headline Targeting Flexible Headline Targeting Flexible Core Targeting Strict Headline Targeting Flexible Headline Targeting Flexible Core Targeting Welfare gain (in % of strict core inflation targeting consumption) -0.07 -0.22 -0.19 3.21 4.18 1.58

Explanation of results



Constrained households’ demand

insensitive to interest rate fluctuations,

determined by real wages



Financial friction – establishes a link

between real income of constrained

consumers and aggregate demand



So, price in flexible price sector affects

aggregate demand



In order to affect aggregate demand,

central bank must stabilize prices in

flexible price sector



Also, inflation and output may move in

opposite directions – stabilizing output

gap is welfare improving

Sensitivity analysis



Without subsistence level of food

consumption



Elasticity of substitution between food

and non food



Lots of additional analysis of sensitivity

to model parameters

Extensions



Alternate characterization of

complete markets



More general setting – where

households in either sector can be

credit constrained

Alternate complete market setting



In most models – households can insure

fully against income risks ex- ante



We look at setting– when households can

Results under alternate complete market

settings

Elasticity of Substitution Flexible Headline Inflation Targeting

0.6a 0.24

0.7 0.05

Results under alternate complete market

settings

Elasticity of Substitution Flexible Headline Inflation Targeting

0.6a 0.24

0.7 0.05

Complete general market setting



A fraction of people in both sectors

are credit constrained



We choose the fractions such that

overall 50% of the households in the

economy are credit constrained

Results of general market setting

Fraction of households in sticky price sector with access to formal finance Fraction of households in flexible price sector with access to formal finance Welfare gains from flexible headline inflation targeting 0.10 0.90 0.38 0.20 0.80 0.22 0.30 0.70 0.21 0.40 0.60 0.22 0.50 0.50 0.24 0.60 0.40 0.26 0.70 0.30 0.28 0.80 0.20 0.29 0.90 0.10 0.30

Conclusions



In the presence of financial frictions – core

inflation targeting not optimal



Presence of credit constrained consumers –

establishes a link between price in the

flexible price sector and aggregate demand



Since inflation and output may move in

opposite direction – targeting flexible

headline inflation optimal

Policy implications, broader intuition



In real world, central bank has to respond to

food price volatility from a pure welfare

perspective



Inflation expectations another channel



Sub-optimal response to supply shocks

New challenges facing central banks



Sovereign debt rising; financial repression?



Exchange rate