There has recently been much interest in the effects of changes in commodity prices on output and inflation. Some research, for example, has suggested that the fall in commodity prices was the key to the success of the British disinflation programme under Mrs Thatcher and has been a major influence on the UK wage-price process since the mid-1960s. The importance of commodity prices is also reflected in the recent American proposal that a commodity price index should be one of the indicators to which international macroeconomic policy should respond.
In Discussion Paper No. 271, Thomas Moutos and Research Fellow David Vines analyse interdependence between commodity prices and the rest of the macroeconomy in a world containing two goods, manufactured output and primary commodities, and where the supply of the latter is determined exogenously. Primary commodities, in addition to their conventional uses, serve as a means of storing wealth; in this capacity they are assumed to be a perfect substitute for bonds. The price of primary commodities undergoes discrete jumps to ensure that the rate of return on commodities is equal to that on bonds, analogous to the behaviour of floating exchange rates in the `Dornbusch model'.
Moutos and Vines analyse the effects both on output and on prices of changes in government spending, the money supply, the rate of monetary growth, and an increase in the exogenous supply of primary commodities. They find that, in some circumstances, commodity prices `overshoot' their new steady-state equilibrium values in response to changes in monetary policy and thereby contribute to the reduction of inflation. This parallels the aid that the disinflation process can get in its initial stages from an overshooting appreciation of the exchange rate; but this effect is dependent on the parameters of the authors' model and is not therefore inevitable.
Moutos and Vines's analysis also shows that extra government spending on manufactured goods reduces the relative prices of commodities. If commodities are perfectly substitutable with bonds, fiscal expansion can lead to permanently higher output. If commodities and bonds are not perfectly substitutable, however, no such long-run expansion in output can occur. Finally, Moutos and Vines show that an exogenous increase in the supply of primary commodities also increases output and may lead to overshooting of commodity prices, again depending on the degree of substitutability between commodities and bonds.
The authors note a fundamental weakness in their model: the assumption that commodity stocks are always held, so that the response to a reduction in the supply of commodities is the mirror image of the response to an increase in their supply. But unlike the rate of return on financial assets, the normal rate of return on commodities is negative (due to storage costs), and significant stockholding does not always occur. Commodity stocks will be held following a drop in their price, due to a good harvest or a drop in demand, if the expected subsequent rise in commodity prices is sufficient to outweigh the costs of holding wealth in commodities rather than interest-yielding financial assets. By contrast, following a poor harvest or an increase in commodity demand, commodity stocks would be very low, so that the price response to a reduction in commodity supply would be greater than that following an increase in supply. A model incorporating this behaviour would be more realistic but also more complex than the one Moutos and Vines employ

Output, Inflation and Commodity Prices Thomas Moutos and David Vines

Discussion Paper No. 271, September 1988 (IM/IT)