Commodity Price Fluctuations and Monetary Policy in Small Open Economies
Increased volatility in the world prices of commodities such as oil and food, which are basic imports for many countries, has rekindled interest on the question of how monetary policy should best adjust to external commodity price movements. Recent studies have analyzed the issue in the New Keynesian framework of Woodford (2003) and Gali (2008), adapted and extended to an open economy. As emphasized by Corsetti, Dedola, and Leduc (2010), optimal monetary policy then must balance at least two considerations. The first one is to counteract domestic distortions related to nominal price rigidities and price setting behavior. This is most critical in closed economies and, as emphasized by Woodford (2003), often results in a prescription that the monetary policy should aim at stabilizing of a producer price index (PPI). The second consideration is that it can be beneficial for a small economy to use monetary policy ∗Much of the analysis here draws on joint work with Luis Catao, to whom I am heavily in debt. I also thank Rodrigo Caputo and Andres Fernandez for useful comments and suggestions. This paper was prepared for the 2014 Annual Conference of the Central Bank of Chile. The Central Bank of Chile’s financial support is acknowledged with thanks. Of course, I am solely responsible for the views expressed here and any errors or omissions.