RDP 2009-10: Global Relative Price Shocks: The Role of Macroeconomic Policies 8. Conclusions

This paper considers a stylised representation of three major shocks affecting the global economy during the period from 2002 to 2008. These shocks were: a large rise in the productivity growth of manufactures relative to non-manufacturing sectors in developing economies; a fall in global risk premia; and the relatively easy monetary policy stance of the FRB starting after the bursting of the dotcom bubble in 2001 and lasting up until the early part of 2006. The three shocks are considered in a global model that captures the interdependencies between economies at both the macroeconomic and sectoral levels.

There are a number of insights that suggest a need for further empirical analysis. The first is that the shift in relative prices observed since 2002 can be partly explained by the adjustment in the model in response to the assumed shocks, however, the scale of the actual rise in the prices of energy, mining and agriculture relative to manufacturing since 2004 are not well captured. Other factors outside the fundamentals in the model are needed to explain the scale of this more recent experience. The second insight is that the model suggests that there was some contribution to global inflation due to the FRB keeping interest rates low after the bursting of the dot-com bubble in 2001, and that this effect was reinforced by the fact that the Chinese and other monetary authorities pegged to the US dollar. However, the effect on global relative prices of US monetary policy is relatively small compared to the productivity shocks in developing economies. One interpretation of these results is that the short-term deflationary impact of developing economy productivity growth on the US economy was to a large extent neutralised in the United States by the change in FRB policy as modelled in this paper.

An interesting conclusion of the simulations in this paper is that monetary policy tends to affect relative prices for up to four years because the effect of a temporary change in real interest rates varies across sectors. The effect depends on each sector's relative capital intensity as well as on the change in the demand for the output of each sector as consumption and investment adjust. Eventually the effect of monetary policy on relative prices dissipates.

Interestingly, a country that pegs to the US dollar when the United States relaxes monetary policy inherits both the overall inflationary consequences of the US policy shift as well as the dispersion in relative prices, although this partly depends on the relative capital intensity of the sectors in the pegging economy. A country, such as Australia, which maintains a flexible exchange rate is largely shielded from the inflationary effect of changes in US monetary policy (via an appreciation of the exchange rate) but it is not shielded from the relative price effects. These are transmitted through global trade channels and are even larger when a significant part of the world economy pegs to the US dollar and experiences similar inflationary and relative price movements.

Finally, it is important to note that there are many caveats surrounding the methodology adopted in this paper. It is not meant to be a definitive empirical assessment of the role of various shocks in the world economy between 2002 and 2008. Rather, it is meant to give some insights into the relationships between relative prices and overall inflation in a world characterised by a variety of different shocks.