RDP 2009-10: Global Relative Price Shocks: The Role of Macroeconomic Policies 3. Monetary Policies Around the World

To some extent, the dramatic changes in relative prices could be the result of a combination of monetary policies adopted in the United States, China and elsewhere in the world. Following the events of 11 September 2001, the bursting of the dot-com bubble and at the onset of the 2001–2002 recession, the Federal Reserve Board (FRB) lowered interest rates aggressively, only gradually increasing rates as the US economy recovered (Figure 3). By fixing its exchange rate to the US dollar for a prolonged period of time after devaluing its currency in 1993 (Figure 4), China substantially reduced exchange rate risk for investors. The fixed exchange rate regime adopted by China, combined with the large interest rate differential that resulted from China not adjusting its interest rates to the same extent as the United States, encouraged firms to borrow in US dollars to invest in China, receiving higher returns with little fear of a devaluation of the Chinese currency. This is evident in the rapid growth of the gross flow of foreign direct investment into China, from US$47 billion in 2001 to US$108 billion in 2008, driven mainly by firms domiciled in east Asia, particularly from Hong Kong (Figure 5). Also, China's foreign exchange reserves grew exponentially – foreign reserves by July 2009 were about US$2.1 trillion, 10 times their level at the beginning of 2002 (Figure 4) – and gross fixed capital formation as a share of GDP rose quite rapidly in China (Figure 6). This boom in investment led directly to increased demand for raw materials and a large increase in commodity prices, particularly energy prices. Even as China increased interest rates and used other tools to tighten monetary policy, such as increasing its reserve requirement ratio (Figure 7), investment remained high and foreign direct investment rose rapidly. While the increase in the reserve requirement ratio acted to restrict lending by banks in China (Figure 8), it did not stop firms reinvesting their profits nor did it slow the inflow of foreign direct investment.

Import prices from countries such as China clearly exerted some downward pressure on US inflation. Although some have argued that US monetary policy was too easy between 2002 and 2006, it is difficult to argue that US monetary policy alone was behind the large movement in relative prices. The United States, during this period, was increasing its imports from China, to the point where China was close to becoming the largest source of US imports (Figure 9). This was the result of the lower prices of goods imported from China, mainly at the expense of imports from Mexico. The resulting downward pressure on inflation enabled the FRB to keep nominal interest rates reasonably low without risking rising inflation for prices of goods and services. Conversely, import prices from commodity-producing countries were rising rapidly (Figure 10), although some of this movement, especially between the middle of 2005 and the middle of 2008, could be attributed to the depreciation of the US dollar. The price of imports from China began to rise in 2006 following China's move to revalue its currency against the US dollar.

In the remainder of this paper, we apply a sequence of shocks to the multi-sector global G-Cubed model to see the extent to which the relative price movements that were observed across six different sectors can be replicated. The six sectors are: agriculture, mining, energy, durable manufactures, non-durable manufactures and services. Although the model contains many economies, we focus on just three: the United States, China and Australia. The shocks we consider are those to productivity, risk premia and monetary policy. We use these shocks to approximate some of the key features of the data, namely the large relative price movements and the boom in investment, particularly in China and other developing economies.