RDP 2015-11: Unprecedented Changes in the Terms of Trade 3. Temporary and Permanent Changes in Commodity Prices

In this section we illustrate the responses of economic variables to temporary and permanent changes in commodity prices in our model and discuss how these responses allow us to identify shifts in long-run commodity prices.

The responses of commodity prices to temporary and permanent shocks are different. We reproduce Equation 3 here to illustrate how:

A positive temporary shock, u_κ,t, raises commodity prices on impact, but implies an expected path of falling commodity prices as they revert to their original steady state.^[5] In contrast, the contemporaneous impact of a permanent change in the long-run level of commodity prices, Δκ, is dampened by the persistence of the process, so that the initial increase is only (1−ρ_κ) log(Δκ). But it implies an expected path of commodity prices to a permanently higher level.

To illustrate the economic implications of these alternative commodity price paths, Figure 2 compares similarly sized temporary and permanent shocks to commodity prices. For this exercise, we set the parameters of the model to the posterior mode of our estimates below. Also in line with our estimates, we scale the shocks to induce a 42 per cent increase in commodity prices.

In some respects, temporary and permanent commodity price increases have similar effects on the economy. Both raise the income of domestic residents. This causes an expansion in domestic demand and an increase in non-tradeable inflation. Similarly, temporary and permanent commodity price increases both prompt an exchange rate appreciation that lowers the inflation rate of tradeable goods and services.

However, although the direction of the responses of many variables are the same, the magnitudes are different. Following a permanent increase in commodity prices, the initial appreciation of the exchange rate is estimated to be half as large as the long-run change in commodity prices. In contrast, following a temporary increase, the appreciation of the exchange rate is only five per cent as large as the change in commodity prices. Because the determination of the exchange rate depends on expectations, it appreciates by more when the change in commodity prices is permanent in anticipation of larger future inflows of foreign currency. These inflows are larger not only because commodity prices are expected to be permanently higher but also because commodity sector output expands permanently. The price effect is magnified by a quantity effect when the change in commodity prices is permanent.

Inflation provides another example of the difference between temporary and permanent changes in commodity prices. Once again, permanent changes have much larger effects on both tradeable and non-tradeable inflation than temporary changes. But the fall in tradeable inflation is particularly large when the change in commodity prices is permanent, due to the larger exchange rate appreciation. As a result, in the permanent case aggregate inflation is estimated to fall by 2 percentage points for a short time because the deflationary impact of lower import prices dominates the increase in non-tradeable prices that comes from rising incomes. In contrast, a temporary increase in commodity prices is estimated to be mildly inflationary.

These different inflation responses have implications for interest rates. A permanent increase in commodity prices initially puts downward pressure on nominal interest rates due to the disinflation and an initial contraction in output. Eventually, nominal interest rates increase as the disinflationary effect of the exchange rate appreciation diminishes and output growth remains higher in the transition to the new steady state. In contrast, a temporary increase in commodity prices leads to higher interest rates immediately.

In the case of temporary changes in commodity prices, the increase in consumption and investment is smaller than the change in domestic incomes. Domestic residents save part of the temporary income boost and the net exports to GDP ratio increases. In contrast, a permanent increase in commodity prices raises expected long-run income by more than short-run income. Reflecting these expectations, consumption and investment expand by more than the initial increase in income and the net exports to GDP ratio decreases.

Permanent and temporary changes in commodity prices also have different implications for production. When the change in commodity prices is permanent, the commodity sector initially contracts. An increase in the long-run level of commodity prices has a relatively small contemporaneous impact on foreign-currency commodity prices. But the nominal exchange rate appreciates immediately, which lowers the domestic-currency revenue of the commodity sector. As a consequence, the domestic-currency price of commodities initially falls before reaching a permanently higher level. This delays the expansion of the commodity sector. In contrast, a temporary increase in commodity prices induces an immediate expansion in commodity output.^[6]

Higher long-run commodity prices also cause an expansion of the non-tradeable sector. For the non-commodity tradeable sector, domestic demand rises when commodity prices increase permanently. But the exchange rate appreciation causes a significant fall in foreign demand. Overall, non-commodity tradeable production initially contracts. Along the transition to a new balanced growth path, production in this sector experiences a brief recovery due to the expansion in domestic demand. However, a permanent increase in commodity prices ultimately causes a reallocation of inputs across sectors. The commodity sector and non-tradeable sector expand to take advantage of higher prices, while the non-commodity tradeable sector contracts.

In sum, even when the direction of the responses of macroeconomic variables to temporary and permanent commodity price movements are the same, the magnitude of the responses are often very different. And for some variables, for example inflation and the trade balance, even the direction of their responses to commodity price changes depends on the permanence of the changes. It is these differences that allow our estimation procedure to distinguish between permanent and temporary movements in commodity prices.

Footnotes

We assume that |ρ_κ| < 1, implying that κ_t is stationary. [5]

In our sample, actual changes in commodity prices included a mix of temporary and permanent components. Consequently, the net effect of price changes on the commodity sector was somewhere in between these two cases. [6]