How Should Central Banks Respond to Commodity Price Shocks? Optimal Monetary and Exchange Rate Frameworks for Commodity-Exposed Economies

We show that the optimal monetary policy and exchange rate framework depend critically on the economy’s commodity exposure. We develop a flexible but tractable model economy with commodity exports and imports, in which international financial conditions may vary with the commodity cycle, and we compute the welfare-optimal policy in the presence of price and wage rigidities. Stabilizing domestic prices is welfare-optimal for commodity exporters, in line with standard open-economy policy prescriptions. But for economies that use commodities as inputs in production, optimal policy largely ‘looks through’ the direct and indirect effects of commodity shocks on domestic prices; this contrasts with some earlier findings and policy practice (which only ‘looks through’ the direct effect). Exchange-rate pegs increase welfare for commodity importers because they stabilize wages and employment, though it is not a robustly optimal policy. In emerging and developing economies, where financial conditions are more tied to the commodity cycle, trade-offs are starker and implementing the optimal policy may be challenging, since it requires enough credibility to keep inflation expectations anchored amidst greater volatility in some nominal variables.