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Coping with Commodity Volatility: Macroeconomic Policies for Developing Countries. Jeffrey Frankel Harpel Professor of Capital Formation & Growth. May 24, 2013. In 2008, the government of Chilean President Bachelet & her Finance Minister Velasco ranked low in public opinion polls.

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coping with commodity volatility macroeconomic policies for developing countries

Coping with Commodity Volatility:Macroeconomic Policies for Developing Countries

Jeffrey FrankelHarpel Professor of Capital Formation & Growth

May 24, 2013

In 2008, the government of Chilean President Bachelet& her FinanceMinisterVelasco ranked low in publicopinionpolls.

By late 2009, they were the most popular in 20 years. Why?

Evolution of approval and disapproval of four Chilean presidents

PresidentsPatricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle BacheletData: CEP, Encuesta Nacional de Opinion Publica, October 2009, Source: Engel et al (2011).

commodity exporters face extra volatility in their terms of trade
Commodity exporters face extra volatility in their terms of trade
  • Choices of macroeconomic policies & institutions can help manage the volatility.
  • Too often, historically, they have exacerbated it:
  • Pro-cyclical macroeconomics
    • (i) capital flows, money, credit;
    • (ii) currency policy; relative price of nontraded goods;
    • and (iii) fiscal policy.
i pro cyclical capital flows
(i) Pro-cyclical capital flows
  • According to intertemporal optimization theory, capital flows should be countercyclical:
    • flowing in when exports do badly
    • and flowing out when exports do well.
  • In practice, it does not always work this way. Capital flows are more procyclical than countercyclical.
    • Gavin, Hausmann, Perotti &Talvi (1996); Kaminsky, Reinhart&Vegh (2005); Reinhart&Reinhart (2009); and Mendoza&Terrones (2008).
  • Theories to explain this involve capital market imperfections,
        • e.g., asymmetric information or the need for collateral.
ii pro cyclical monetary policy
(ii) Pro-cyclical monetary policy
  • If the exchange rate is fixed,
    • surpluses during commodity booms can lead to:
      • Rising reserves
      • Excessive money & credit
      • Excess demand for goods; overheating
      • Inflation
      • Asset bubbles.
macro effects of commodity boom
Macro effects of commodity boom
  • Inflation shows up especially in non-traded goods & services, like construction.
Pro-cyclical real exchange rateCountries undergoing a commodity boom experience real appreciation of their currency

The resulting shift of land, labor & capital out of manufacturing, and into the booming commodity sectormight be appropriate & inevitable,

to the extent it is expandable,

especially if the commodity boom is permanent.

But the shift out of manufacturing into NTGs is often an undesirable macroeconomic side effect –

the “disease” part of Dutch Disease.

iii procyclical fiscal policy
(iii) Procyclical fiscal policy
  • Fiscal policy has historically tended to be procyclical in developing countries
    • especially among commodity exporters:

Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart & Végh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini(2008), Mendoza & Oviedo (2006), Ilzetski & Végh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997).

    • Correlation of income & spending mostly positive –
      • in comparison with industrialized countries.

Correlations between Gov.t Spending & GDP




Adapted from Kaminsky, Reinhart & Vegh (2004)


G always used to be pro-cyclical for most developing countries.

The procyclicality of fiscal policy

A reason for procyclical public spending: receipts from taxes&royalties rise in booms.The government cannot resist the temptation to increase spending proportionately, or more.

Then it is forced to contract in recessions,

thereby exacerbating the swings.


two budget items account for much of the spending from oil booms
Two budget items account for much of the spending from oil booms:

(i) Investment projects.

Investment in practice may be “whiteelephant” projects,

which are stranded without funds for completion or maintenance when the oil price goes back down.

Gelb (1986).

(ii) The government wage bill.

Oil windfalls are often spent on public sector wages.

Medas & Zakharova (2009)

Arezki & Ismail(2010): government spending rises in booms, but is downward-sticky.

Rumbi Sithole took this photo in “Bayelsa Statein the Niger Delta,in Nigeria. The state government received a windfall of money and didn't have the capacity to have it all absorbed in social services so they decided to build a Hilton Hotel. The construction company did a shoddy job, so the tower

is leaning to its right and it’s unsalvageable..”


An important development -- some developing countries, including commodity producers, were able to break the historic pattern in the most recent decade:

taking advantage of the boom of 2002-2008

to run budget surpluses & build reserves,

thereby earning the ability to expand fiscally in the 2008-09 crisis.

Chile, Botswana, Malaysia, Indonesia, Korea…

How were they able to achieve counter-cyclicality?

The procyclicality of fiscal policy,cont.


correlations between government spending gdp 2000 2009
Correlations between Government spending & GDP 2000-2009


Frankel, Vegh & Vuletin(2012)

In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP.


four questions for macro management
1. How can a country avoid excessive credit creation & inflation in a commodity boom ?

Eventually allow some currency appreciation.

But not a free float. Accumulate some fx reserves first.

2. Nominal anchor for monetary policy:

What is it to be, if not the exchange rate? CPI?

3. Fiscal policy:How can governments be constrained from over-spending in boom times? Fiscal rule?

4. What microeconomic arrangements can reduce macroeconomic volatility?

Four questions for macro management
1) The challenge of designinga monetary regime for countries where terms of trade shocks dominate the cycle
  • Fixingthe exchange rateleads to pro-cyclical monetary policy:
    • Money flows in during commodity booms.
      • Excessive credit creation can lead to inflation.
      • Example: Saudi Arabia & UAEduring the 2003-08 oil boom.
    • Money flows out during commodity busts.
      • Credit squeeze can lead to excess supply, recession & balance of payments crisis.
      • Example: Exporters of oil & other commodities in 1980s or 1997-98.
currency regime continued
Currency regime, continued
  • Floatingaccommodates terms of trade shocks:
    • If terms of trade improve, currency automatically appreciates,
      • preventing excessive money inflows, overheating & inflation.
    • If terms of trade worsen, currency automatically depreciates,
      • preventing recession & balance of payments crisis.
  • Disadvantages of floating:
    • Volatility can be excessive;
    • Dutch Disease can be worse:
      • pro-cyclicality of real exchange rate.
    • One needs a nominal anchor.
demand vs supply shocks
Demand vs. supply shocks

An old wisdom regarding the source of shocks:

Fixed rates work best if shocks are mostly internal demand shocks (especially monetary);

floating rates work best if shocks tend to be real shocks (especially external terms of trade).

One set of supply shocks: natural disasters

R.Ramcharan (2007) finds floating works better.

A common source of real shocks: trade.

terms of trade variability
Terms-of-trade variability

Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008 & 2011.

=> Favorable terms of trade shocks for some (oil producers, Africa, Latin America, etc.);

=> Unfavorable terms of trade shock for others (oil importers such as Japan, Korea).

Textbook theory says a country where trade shocks dominate should accommodate by floating.

Confirmed empirically:

Developing countries facing terms of trade shocks do better with flexible exchange rates than fixed exchange rates.

Broda (2004),Edwards & L.Yeyati (2005), Rafiq(2011), andCéspedes & Velasco (2012)…


Céspedes &Velasco(Nov.2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts”

Constant term

not reported.

(t-statistics in parentheses.)

** Statistically significant at 5% level.

Across 107 major commodity boom-bust cycles,

output loss is bigger the bigger is the commodity pricechange & thesmallerisexchangerate flexibility.

monetary regime if the exchange rate is not to be the monetary anchor what is
Monetary regimeIf the exchange rate is not to be the monetary anchor, what is?

The popular choice of the last decade:Inflation Targeting.

But CPI targeting can react perversely

to supply shocks

& terms of trade shocks.

needed nominal anchors that accommodate the shocks that are common in developing countries
Needed:Nominal anchors that accommodate the shocks that are common in developing countries
  • Supply shocks,
    • e.g., droughts, floods, hurricanes:
    • Nominal GDP targeting.
  • Terms of trade shocks
    • e.g., fall in price of commodity export.
    • Product Price Targeting


nominal gdp target cancels out velocity shocks vs m target moderates effects of supply shocks vs it
Nominal GDP targetcancels out velocity shocks (vs. M target) & moderates effects of supply shocks(vs. IT)

Adverse AS shock






Real GDP

does nominal gdp target give best output inflation trade off
Does NominalGDPtarget give best output/inflation trade-off?

It gives exactly the right answer if the simple Taylor Rule’s equal weights accurately capture what discretion would do.

Even if not exact, the “true” objective function would have to put far more weight on P than output, or AS would have to be very steep, for the P rule to give a better outcome.

Adverse AS shock





Real GDP



accommodates terms of trade shocks


  • Targetanindex ofdomesticproductionprices[1]such as the GDP deflator.
  • Include export commodities in the index & exclude import commodities,
      • so money tightens & the currency appreciates when world prices of export commodities rise
        • accommodating the terms of trade --
        • not when prices of import commodities rise.
  • The CPI does it backwards:
    • It calls for appreciation when import prices rise,
    • not when export prices rise ! [1] Frankel (2011, 2012).
why is ppt better than a fixed exchange rate for countries with volatile export prices
Why is PPT better than a fixed exchange ratefor countries with volatile export prices?

If the $ price of the export commodity goes up, the currency automatically appreciates,

moderating the boom.

If the $ price of export commodity goes down, the currency automatically depreciates,

moderating the downturn

& improving the balance of payments.


why is ppt better than cpi targeting for countries with volatile terms of trade
Why is PPT better than CPI-targetingfor countries with volatile terms of trade?

If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate the currency.

Wrong response.(E.g., oil-importers in 2007-08.)

PPT does not have this flaw .

If the $ price of the export commodity goes up, PPT says to tighten money enough to appreciate.

Right response.(E.g., Gulf currencies in 2007-08.)

CPI targeting does not have this advantage.


elaboration on p roduct p rice t argeting
Elaboration onProduct Price Targeting

Each of the traditional candidates for nominal anchor has an Achilles heel.

The CPI anchor does not accommodate terms of trade changes:

IT tightensM&appreciates when import prices rise

not when export prices rise,

which is backwards.

Targeting core CPI does not much help.



6 proposed nominal targets and the Achilles heel of each:



Professor Jeffrey Frankel


Is Inflation Targeting the reigning orthodoxy at the Fund? “Yes”

  • 2006: 100%
  • 2007: 63%
  • 2008: 72%
  • 2010: 58%
  • 2011 97%Do you personally believe in IT? 38%
3 how can countries avoid pro cyclical fiscal policy
3. How Can Countries Avoid Pro-cyclical Fiscal Policy?
  • “Good institutions.”
  • But what are they, exactly?

Who achieves counter-cyclical fiscal policy?

Countries with “good institutions”

”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J.Dev.Economics, 2013.

the quality of institutions varies not just across countries but also across time
The quality of institutions varies, not just across countries, but also across time.


Frankel, Végh & Vuletin,2013.


The comparison holds not only in cross-section,but also across time.

”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J. Devel. Econ., 2013.

how can countries avoid fiscal expansion in booms
How can countries avoid fiscal expansion in booms?
  • Whatare“good institutions,” exactly?
  • Rules?
    • Budget deficits or debt brakes?
      • Have been tried many times. Usually fail.
    • Rules for cyclically adjusted budgets?
      • Countries more likely to be able to stick with them. But…
  • An under-explored problem:
    • Over-optimism in official forecasts
      • of growth rates & budgets.
over optimism in official forecasts
Over-optimism in official forecasts
  • Statistically significant bias among 33 countries
    • Worse in booms.
    • Worse at 3-year horizons than 1-year.
    • Frankel (2011, 2012).
  • Leads to pro-cyclical fiscal policy:
    • If the boom is forecast to last indefinitely, there is no apparent need to retrench.
  • BD rules don’t help.
    • The SGP worsens forecast bias for euro countries.
    • Cyclically adjusted rules won’t help the bias either.
    • Frankel & Schreger (2013).
  • Solution?
1st rule – Governments must set a budget target,

2nd rule – The target is structural: Deficits allowed only to the extent that

(1) output falls short of trend, in a recession, or

(2) the price of copper is below its trend.

3rd rule – The trends are projected by 2 panels of independentexperts, outside the politicalprocess.

Result: Chile avoided the pattern of 32 other governments,

where forecasts in booms were biased toward optimism.

The example of Chile’s fiscal institutions

chilean fiscal institutions
Chilean fiscal institutions

In 2000 Chile instituted its structural budget rule.

The institution was formalized into law in 2006.

The structural budget surplus must be…

0 as of 2008 (was higher before, lower after),

where “structural” is defined by output & copper price equal to their long-run trend values.

I.e., in a boom the government can only spend increased revenues that are deemed permanent; any temporary copper bonanzas must be saved.

Chile’s fiscal position strengthened immediately:

Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005

allowing national saving to rise from 21 % to 24 %.

Government debt fell sharply as a share of GDP and the sovereign spread gradually declined.

By 2006, Chile achieved a sovereign debt rating of A,

several notches ahead of Latin American peers.

By 2007 it had become a net creditor.

By 2010, Chile’s sovereign rating had climbed to A+,

ahead of some advanced countries.

=> It was able to respond to the 2008-09 recession.

The Pay-off

In 2008, with copper prices spiking up, the government of President Bachelet had beenunder intense pressure to spend the revenue.

She & Fin.Min.Velasco held to the rule, saving most of it.

Their popularity fell sharply.

When the recession hit and the copper price came back down, the government increased spending, mitigating the downturn.

Bachelet&Velasco’s popularity reached historic highs by the time they left office.

5 econometric findings regarding bias toward optimism in official budget forecasts
5 econometric findings regarding bias toward optimism in official budget forecasts.

Official forecasts in a sample of 33 countries on average are overly optimistic, for:

(1) budgets &

(2) GDP .

The bias toward optimism is:

(3) stronger the longer the forecast horizon;

(4) greater in booms

(5) greater for eurogovernments underSGPbudgetrules;


The optimism in official budget forecasts is stronger at the 3-year horizon, stronger amongcountries with budget rules,

& stronger in booms.

Frankel, 2010, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

5 more econometric findings regarding bias toward optimism in official budget forecasts
5 more econometric findings regarding bias toward optimism in official budget forecasts.

(6) The key macroeconomic input for budget forecasting in most countries: GDP. In Chile: the copper price.

(7) Real copper prices revert to trend in the long run.

But this is not always readily perceived:

(8) 30 years of data are not enough

to reject a random walk statistically;200 years of data are needed.

(9) Uncertainty(option-implied volatility)is higher when copper prices are toward the top of the cycle.

(10) Chile’s official forecasts are not overly optimistic.It has apparently avoided the problem of forecasts that unrealistically extrapolate in boom times.

in sum institutions recommended to make fiscal policy less procyclical
In sum, institutions recommended to make fiscal policy less procyclical:

Chile is not subject to the same bias toward over-optimism in forecasts of the budget, growth, or the all-important copper price.

The key innovation that has allowed Chile to achieve countercyclical fiscal policy:

not just a structural budget rule in itself,

but rather the regime that entrusts to two panels of experts estimation of the long-run trends of copper prices & GDP,

insulated from political pressure & wishful thinking

application to others
Application to others

Any country could emulate the Chilean mechanism,

or in other ways delegate to independent agencies.

Suggestion: give panels more institutional independence

as is familiar from central banking:

laws protecting them from being fired.

Open questions:

How much of the structural budget calculations are to be delegated to the independent panels of experts?

Minimalist approach: they compute only 10-year moving averages.

Can one guard against subversion of the institutions (CBO) ?

Contractual provisions to share risks:

1. Index contracts with foreign companiesto the world commodity price.

2. Hedge commodity revenues in options markets.

3. Denominate debt in terms of commodity price .

Manage commodity funds professionally.

4. Other reforms to manage volatility

Norway’s Pension Fund

All govt. oil revenues go into it.

Govermnent(on average over the cycle) can spend expected real return, say 4%.

All invested abroad. Reasons:

(1) for diversification,

(2) to avoid cronyism in investments.

But insulated from politics,

like Botswana’s Pula Fund,

fully delegated for financial optimization.

Manage commodityfunds professionally.

references by the author
References by the author

Project Syndicate,

“Escaping the Oil Curse,”  Dec.9, 2011.

"Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility,"  Oct.17, 2011. 

“The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries , R.Arezki et al., eds. (IMF); HKS RWP12-014. 

“How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” inNatural Resources, Finance & Development.R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011.  HKS RWP 11-015.

“On Graduation from Fiscal Procyclicality,”with C.Végh & G.Vuletin, inJournalof Development Economics, 100, no.1, Jan.2013; pp. 32-47.   NBER WP 17619.  Summary, VoxEU, 2011.

Chile's Countercyclical Triumph," inTransitions, Foreign Policy, June 2012.

“A Solution to Fiscal Procyclicality: The StructuralBudget Institutions Pioneered by Chile,” Central Bank of ChileWP604,2011. Spanish:Journal Economía Chilena , Aug.2011, CBC, 39-78.

"Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore).

“A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, 2011 (Brookings), NBER WP 16362.

references by others
References by others

Rabah Arezki and Kareem Ismail, 2010, “Boom-Bust Cycle, Asymmetrical Fiscal Response and the Dutch Disease,” IMF WP/10/94, April.

Christian Broda, 2004, "Terms of Trade and Exchange Rate Regimes in Developing Countries," Journal of International Economics, 63(1), 31-58.

Luis Céspedes & Andrés Velasco, 2012, “Macroeconomic Performance During Commodity Price Booms & Busts” NBER WP 18569, Nov.

GracielaKaminsky, Carmen Reinhart & Carlos Vegh, 2005, "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Macroeconomics Annual 2004, 19, pp.11-82.

Warwick McKibbin & Kanhaiya Singh, “Issues in the Choice of a Monetary Regime for India,” 2003, in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274.

James Meade, 1978, “The Meaning of Internal Balance,” The Economic Journal, 91, 423-35.

Jeffrey Sachs, “How to Handle the Macroeconomics of Oil Wealth,” 2007, in Escaping the Resource Curse, M.Humphreys, J.Sachs & J.Stiglitz, eds. (Columbia Univ. Press: NY), pp. 173-93.