On the Implications of Structural Transformation for Inflation and - PowerPoint PPT Presentation

On the Implications of Structural Transformation for Inflation and Monetary Policy (Work in Progress) Rafael Portillo and Luis–Felipe Zanna IMF Workshop on Fiscal and Monetary Policy in Low–Income Countries International Growth Centre November 2-3, 2012 Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Motivation Many SSA countries re-anchored inflation in the early 2000s. ◮ In the context of fiscal–based stabilization efforts. ◮ Money targeting, to signal stabilization was on track. ◮ Inflation has remained volatile. Some countries are moving toward Inflation Targeting. ◮ The inflation forecast is the intermediate target. ◮ Focus on understanding why inflation deviates from target, determining what policy decisions are necessary (if any) to bring it back in line. What should we expect from inflation in LICs as these countries adopt more modern monetary policy frameworks? Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Motivation LICs find themselves at earlier stages of structural transformation. ◮ Low income per capita (IPC). ◮ Share of spending on agricultural products ( ω F ) is large. ◮ Income and price elasticities for food are lower. ◮ Food shocks should have large effects on food prices ( p F ). ◮ Flexible food prices: p F will also capture any incipient aggregate demand pressures. These features have implications for inflation ( π ): π = π N + ω F ( π F − π N ) = π N + ω F ∆ p F Holding σ π N constant, inflation in LICs should be: (i) volatile, and (ii) dominated by changes in the relative price of food ( ω F ∆ p F ). Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

In this paper We present a simple model of structural transformation to quantify the importance of these features for inflation and monetary policy. Main features: ◮ Two sectors: food and non–food. ◮ Stone–Geary preferences: ω F changes with aggregate TFP. ◮ Food prices are flexible, non–food prices are sticky. ◮ Shocks to food productivity ( e tf ) and monetary policy ( e MP ). ◮ MP: interest rate rule s.t. e tf does not affect π N . ◮ The model encompasses the US and Africa ( ω F , IPC ). ◮ ( σ e tf , σ e MP ) s.t. the model reproduces ( σ π , σ π N , σ ∆ p f ) for US (US serves as benchmark). Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Main findings 1. Structural features amplify the effects of food shocks on p F and on π at earlier stages of economic development. ◮ Effect on output is larger (at earlier stages of development). 2. Structural features also amplify the effects of shocks to monetary policy on inflation at earlier stages of development. ◮ Effect on output is similar. Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Main findings(2) 3. Inflation in the median African country should be 57 percent more volatile than US inflation (∆ p F + 25-45 percent). ◮ Falls short: quarterly inflation (1995:2011) is 300 percent more volatile than US (∆ p F is 200 percent). 4. 54 percent of inflation volatility in the median African country should be accounted by ω ∆ p F (3 percent in the US). ◮ Matches the relative decomposition in the data. 5. The larger the food share (sector), the more costly it is to target headline inflation (in terms of the total output gap). ◮ Greater price flexibility (in the economy) is associated with larger real effects of alternative nominal anchors. Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Related work Structural transformation: Caselli and Coleman (2001), Kongsamut et al (2001), Ngai and Pissarides (2007), Rogerson (2008), among others. Food prices in inflation in emerging markets and low income countries: Catao and Chang (2010), Anand and Prasad (2010), Walsh (2010), IMF WEO (2011), Portillo and Zanna (2012), Adam et al (2012), Andrle et al (2012). Choice of inflation target: Aoki (2001),... Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Stylized facts: Food Share in CPI against GDP per Capita 0.8 0 7 0.7 0.6 0.5 0.4 0.3 0 2 0.2 0.1 0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 Figure: Blue diamonds: countries; dashed red line: log trend; dashed blue line: model. Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Stylized facts: Inflation volatility against GDP per capita 3 2.5 2 1.5 1 0.5 0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 Figure: Blue diamonds: countries. Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Stylized facts: Volatility of ∆ p F against GDP per capita 5 4.5 4 3.5 3 2.5 2 1.5 1 0 5 0.5 0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 Figure: Blue diamonds: countries. Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

The model: Consumers Consumers maximize lifetime utility: � � t − n 1+ ψ ∞ � β t t logc ∗ E 0 1 + ψ t =0 where c ∗ is given by: c F ) α F c 1 − α F c ∗ t = D ( c F , t − ¯ N , t subject to the budget constraint: P F , t c F , t + P N , t c N , t + B t +1 = W t n t + Π t + R t − 1 B t . Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

The model: Consumers First order conditions: n ψ t c ∗− 1 t = w ∗ t � − 1 � P F , t c ∗ F , t = ¯ c F + α F c ∗ t P ∗ t � − 1 � P N , t c ∗ N , t = (1 − α F ) c ∗ t P ∗ t R t c ∗− 1 = β E t [ c ∗− 1 ] t t +1 π ∗ t +1 t = W t P ∗ F , t P 1 − α F t = P α F t w ∗ , P ∗ , π ∗ t = N , t P ∗ P ∗ t t − 1 Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

The model: Food and non–food sector Food : perfectly competitive, flexible prices. Shock to sectoral productivity t t . Non food : monopolistic competitition, sticky prices a la Calvo (1983), employment subsidy. Production function : y i = At t A i n α i , t , for i = N , F . A : economy wide total factor productivity. Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Steady State Steady–state structure of the economy varies with aggregate TFP ( A ). ◮ P N = P F = P ∗ . ◮ w ∗ = A . ◮ c ∗ = f ( A ). ◮ c F = ¯ c F + α F c ∗ , c N = (1 − α F ) c ∗ . ◮ Actual consumption c = c F + c N = ¯ c F + c ∗ . c F + α F c ∗ ¯ ◮ ω F = → α F , as A → ∞ . c F + c ∗ ¯ Income and Price elasticities for food: ◮ Price: α F ω F . ◮ Income: α F ω F . Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Log-linearized version of the model Consumers: p F , t − 1 − α F ψ ˆ n t = ˆ w t + ( ω F − α F )ˆ y t , ˆ 1 − ω F w t = ˆ W t − ˆ where ˆ P t . y t +1 − 1 − ω F � � ˆ ˆ y t = ˆ R t − ˆ π t +1 + ( ω F − α F )∆ˆ p F , t +1 , 1 − α F π t = ˆ P t − ˆ ˆ P t − 1 = ˆ π N , t + ω F ∆ˆ p F , t . y F , t = α F y t − α F ˆ ˆ (1 − ω F )ˆ p F , t ω F ω F y N , t = 1 − α F ˆ ˆ y t + α F ˆ p F , t 1 − ω F Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Log-linearized version of the model Supply side: y t = ω F ˆ ˆ y F , t + (1 − ω F )ˆ y N , t , p F , t = − 1 − α y F , t + 1 ˆ w t − (1 − ω F )ˆ ˆ ˆ t t α α κ � 1 − α w t − ω F � ˆ π N , t = β ˆ ˆ π N , t +1 + y t + ˆ ˆ t t . 1 − ω F α α Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Log-linearized version of the model Monetary Policy ˆ r n R t = (ˆ t + ω F ∆ˆ p F , t +1 ) + ϕ ˆ π N , t + dev t dev t = ρ dev dev t − 1 + e MP Shock to food production ∆ˆ t t = ρ ∆ˆ t t − 1 − ξ ˆ t t − 2 + e tf Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Calibration Parameter Value ¯ c F 0.0099 α F 0.0701 α 0.7 κ 0.0858 ϕ 1.5 ψ 5 ρ 0.8 ρ d ev 0.8 ξ 0.01 σ MP 0.5 σ tf 0.55 Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

Simulations Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

e MP < 0 0 3 2 -0.5 1 0 -1 -1 0 5 10 15 20 0 5 10 15 20 Deviation from monetary policy rule Change in relative price of food 1.5 3 1 2 0.5 1 0 0 0 5 10 15 20 0 5 10 15 20 Non food inflation Headline inflation 1 0.8 0.6 0.5 0.4 0.2 0 0 0 5 10 15 20 0 5 10 15 20 Output Nominal interest rate 0 1.5 Poor country Rich country 1 -0.5 0.5 -1 0 0 5 10 15 20 0 5 10 15 20 Food production Non food production Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy Figure: Blue diamonds: countries.