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On the Implications of Structural Transformation for Inflation and Monetary Policy (Work in Progress) Rafael Portillo and LuisFelipe Zanna IMF Workshop on Fiscal and Monetary Policy in LowIncome Countries International Growth Centre

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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

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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

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Motivation

LICs find themselves at earlier stages of structural transformation.

◮ Low income per capita (IPC). ◮ Share of spending on agricultural products (ωF) is large. ◮ Income and price elasticities for food are lower. ◮ Food shocks should have large effects on food prices (pF). ◮ Flexible food prices: pF will also capture any incipient

aggregate demand pressures. These features have implications for inflation (π): π = πN + ωF (πF − πN) = πN + ωF∆pF Holding σπN constant, inflation in LICs should be: (i) volatile, and (ii) dominated by changes in the relative price of food (ωF∆pF).

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

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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: ωF changes with aggregate TFP. ◮ Food prices are flexible, non–food prices are sticky. ◮ Shocks to food productivity (etf ) and monetary policy (eMP). ◮ MP: interest rate rule s.t. etf does not affect πN. ◮ The model encompasses the US and Africa (ωF, IPC). ◮ (σetf ,σeMP) s.t. the model reproduces (σπ,σπN,σ∆pf ) for US

(US serves as benchmark).

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

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Main findings

  • 1. Structural features amplify the effects of food shocks on pF and
  • n 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

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Main findings(2)

  • 3. Inflation in the median African country should be 57 percent

more volatile than US inflation (∆pF + 25-45 percent).

◮ Falls short: quarterly inflation (1995:2011) is 300 percent

more volatile than US (∆pF is 200 percent).

  • 4. 54 percent of inflation volatility in the median African country

should be accounted by ω∆pF (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

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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

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Stylized facts: Food Share in CPI against GDP per Capita

0 7 0.8 0.6 0.7 0.5 0.4 0 2 0.3 0.1 0.2 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

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Stylized facts: Inflation volatility against GDP per capita

3 2.5 2 1.5 1 0.5 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

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Stylized facts: Volatility of ∆pF against GDP per capita

4.5 5 4 3 3.5 2.5 1.5 2 0 5 1 0.5 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

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The model: Consumers

Consumers maximize lifetime utility: E0

∞

  • t=0

βt

  • logc∗

t − n1+ψ t

1 + ψ

  • where c∗ is given by:

c∗

t = D (cF,t − ¯

cF)αF c1−αF

N,t

subject to the budget constraint: PF,tcF,t + PN,tcN,t + Bt+1 = Wtnt + Πt + Rt−1Bt.

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

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The model: Consumers

First order conditions: nψ

t = w∗ t c∗−1 t

c∗

F,t = ¯

cF + αF PF,t P∗

t

−1 c∗

t

c∗

N,t = (1 − αF)

PN,t P∗

t

−1 c∗

t

c∗−1

t

= βEt[c∗−1

t+1

Rt π∗

t+1

] w∗

t = Wt

P∗

t

, P∗

t = PαF F,tP1−αF N,t

, π∗

t =

P∗

t

P∗

t−1

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

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The model: Food and non–food sector

Food: perfectly competitive, flexible prices. Shock to sectoral productivity tt. Non food: monopolistic competitition, sticky prices a la Calvo (1983), employment subsidy. Production function: yi = AttAinα

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

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Steady State

Steady–state structure of the economy varies with aggregate TFP (A).

◮ PN = PF = P∗. ◮ w∗ = A. ◮ c∗ = f (A). ◮ cF = ¯

cF + αFc∗, cN = (1 − αF)c∗.

◮ Actual consumption c = cF + cN = ¯

cF + c∗.

◮ ωF = ¯ cF +αF c∗ ¯ cF +c∗

→ αF, as A → ∞. Income and Price elasticities for food:

◮ Price: αF ωF . ◮ Income: αF ωF .

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

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Log-linearized version of the model

Consumers: ψˆ nt = ˆ wt + (ωF − αF)ˆ pF,t − 1 − αF 1 − ωF ˆ yt, where ˆ wt = ˆ Wt − ˆ Pt. ˆ yt = ˆ yt+1 − 1 − ωF 1 − αF

  • ˆ

Rt − ˆ πt+1 + (ωF − αF)∆ˆ pF,t+1

  • ,

ˆ πt = ˆ Pt − ˆ Pt−1 = ˆ πN,t + ωF∆ˆ pF,t. ˆ yF,t = αF ωF ˆ yt − αF ωF (1 − ωF)ˆ pF,t ˆ yN,t = 1 − αF 1 − ωF ˆ yt + αF ˆ pF,t

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

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Log-linearized version of the model

Supply side: ˆ yt = ωF ˆ yF,t + (1 − ωF)ˆ yN,t, ˆ wt − (1 − ωF)ˆ pF,t = −1 − α α ˆ yF,t + 1 α ˆ tt ˆ πN,t = βˆ πN,t+1 + κ 1 − ωF 1 − α α ˆ yt + ˆ wt − ωF α ˆ tt

  • .

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

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Log-linearized version of the model

Monetary Policy ˆ Rt = (ˆ rn

t + ωF∆ˆ

pF,t+1) + ϕˆ πN,t + devt devt = ρdevdevt−1 + eMP Shock to food production ∆ˆ tt = ρ∆ˆ tt−1 − ξˆ tt−2 + etf

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

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Calibration

Parameter Value ¯ cF 0.0099 αF 0.0701 α 0.7 κ 0.0858 ϕ 1.5 ψ 5 ρ 0.8 ρdev 0.8 ξ 0.01 σMP 0.5 σtf 0.55

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

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Simulations

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

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eMP < 0

5 10 15 20

  • 1
  • 0.5

Deviation from monetary policy rule 5 10 15 20

  • 1

1 2 3 Change in relative price of food 5 10 15 20 0.5 1 1.5 Non food inflation 5 10 15 20 1 2 3 Headline inflation 5 10 15 20 0.5 1 Output 5 10 15 20 0.2 0.4 0.6 0.8 Nominal interest rate 5 10 15 20

  • 1
  • 0.5

Food production 5 10 15 20 0.5 1 1.5 Non food production Poor country Rich country

Figure: Blue diamonds: countries.

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

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etf < 0

5 10 15 20

  • 5
  • 4
  • 3
  • 2
  • 1

Productivity in the food sector 5 10 15 20

  • 1

1 2 Change in relative price of food 5 10 15 20

  • 1
  • 0.5

0.5 1 Non food inflation 5 10 15 20

  • 0.5

0.5 1 Headline inflation 5 10 15 20

  • 2
  • 1.5
  • 1
  • 0.5

Output 5 10 15 20

  • 1
  • 0.5

0.5 Natural rate of interest 5 10 15 20

  • 6
  • 4
  • 2

Food production 5 10 15 20

  • 3
  • 2
  • 1

Non food production Poor country Rich country

Figure: Blue diamonds: countries.

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

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Second Order Moments

US

  • Med. Afr

Ratio Rich Poor Ratio Rich Poor Ratio Food share in CPI (percentage) 8.0 39.4 7.93 42.1 GDP per capita 41.7 1.2 2.9% 1 0.03 2.6% PPP (thousands of dollars, avg 2001-2010) Headline inflation 0.29 1.18 4.06 0.04 0.33 0.34 0.44 1.30

(0.03, 0.06) (0.23, 0.45) (0.24, 0.47) (0.32 0.62)

Non Food inflation 0.34 0.74 2.20 0.33 0.32 0.98

(0.22, 0.46) (0.21, 0.43)

Changes in the relative price of food 0.56 1.75 3.14 0.55 0.80 1.45 0.56 0.57 1.02

(0.37, 0.73) (0.54, 1.07) (0.40, 0.82) (0.41, 0.84)

Data Model σ(tf) = 0.55 σ(dev) = 0.50 Volatility (std, BP filtered quarterly data, 1995:I-2011:IV)) Rafael Portillo and Luis–Felipe Zanna IMF Structural Transformation, Inflation and Monetary Policy

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Second Order Moments

US

  • Med. Afr

Ratio Rich Poor Ratio Food share in cpi 8.0 39.4 7.93 42.1 GDP per capita 41.7 1.2 2.9% 1 0.03 2.6% PPP (thousands of dollars, avg 2001-2010) Headline inflation 0.29 1.18 4.06 0.35 0.55 1.57

(0.25, 0.49) (0.37, 0.66)

Non Food inflation 0.34 0.74 2.20 0.33 0.30 0.93

(0.22, 0.46) (0.21, 0.43)

Changes in the relative price of food 0.56 1.75 3.14 0.75 0.94 1.25

(0.54, 1.03) (0.67, 1.30)

Non food 1.11 0.75 0.89 0.32 food weight* changes in the relative pri 0.02 0.52 0.03 0.54 Data Model σ(tf) = 0.55, σ(dev) = 0.50 Volatility (std deviations, BP filtered quarterly data, 1995:I-2011:IV)) Inflation decomposition

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

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ˆ πt = 0

5 10 15 20

  • 5
  • 4
  • 3
  • 2
  • 1

Productivity in the food sector 5 10 15 20

  • 0.5

0.5 1 1.5 Change in relative price of food 5 10 15 20

  • 0.6
  • 0.4
  • 0.2

0.2 Non food inflation 5 10 15 20

  • 1
  • 0.5

0.5 1 Headline inflation 5 10 15 20

  • 2
  • 1.5
  • 1
  • 0.5

Output 5 10 15 20

  • 0.6
  • 0.4
  • 0.2

0.2 Policy Rate 5 10 15 20

  • 6
  • 4
  • 2

Food production 5 10 15 20

  • 3
  • 2
  • 1

Non food production Poor country Rich country

Figure: Blue diamonds: countries.

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

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Extensions and future work

Incorporate other aspects of structural transformation in the model and assess their quantitative contribution to inflation and relative price volatility. Monetary policy design in LICs in the context of various food shocks. What economic features are necessary to make the volatility of the relative price of food an appropriate objective of monetary policy? Joint work with Chris Adam and Steve O’Connell. Features:

◮ Subsistence requirements in food consumption ◮ Limited financial participation ◮ Real wage rigidities in the non–food sector ◮ Costly internal transport

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

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  • 5. Under Stone-Geary preferences, two distinct price levels emerge.

◮ The measured price level P, with food weight ωF. ◮ A notional price level P∗, with weight αF. ◮ ωF → αF as TFP → ∞, ωF > αF. ◮ P∗, not P, is what matters for private sector decisions. ◮ αF/ωF helps define price and income elasticities.

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

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The model: Food and non–food sector

Food: perfectly competitive, flexible prices. Production is given by: yF,t = AttAFnα

F,t

Non food: a continuum of producers, each producing a variety y(i)N,t. Demand is given by y(i)N,t = yN,t( P(i)N,t

PN,t )−ǫ, with

PN,t = [

  • P(i)1−ǫ

N,t ]

1 1−ǫ . Production is given by:

y(i)F,t = AANn(i)α

N,t

Firms face a random signal that allows them to change prices with probability θ, a la Calvo (1983). Firms also receive an employment subsidy τ.

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