Commodity prices fluctuations and monetary policy in small open ecomomies
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 Galí (2008) adapted and extended to an open economy. As emphasized by Corsetti Dedola and Leduc (2010) optimal monetary policy must then 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 monetary policy should aim at the stabilization of a producer price index (PPI). The second consideration is that it can be beneficial for a small economy to use monetary policy to stabilize an international relative price such as the real exchange rate or the terms of trade.