How should central banks respond to commodity price shocks? Optimal monetary and exchange rate frameworks for commodity-exposed economies

Thomas Drechsel, Michael McLeay, Silvana Tenreyro and Enrico D Turri
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Thomas Drechsel: University of Maryland, NBER, CEPR
Michael McLeay: Bank of England
Silvana Tenreyro: London School of Economics
Enrico D Turri: London School of Economics

No 1186, Bank of England Staff Working Paper series from Bank of England

Abstract: 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. Stabilising 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). 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.

Keywords: Monetary policy; exchange rates; inflation targeting; commodity prices; small open economy (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 F41 Q02 Q30 (search for similar items in EconPapers)
Pages: 54
Date: 2026-06-05
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