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Inflation and Terms-of-trade
This paper argues that, over the longer run, the intertemporal path of inflation in an economy is affected by secular changes in the inter-sectoral terms-of-trade, which in turn, is closely linked to the stages of structural change. This linkage is investigated through simple devices of consumer choice and growth. Results imply that monetary authorities’ inflation targets should optimally account for such secular changes in the terms-of-trade, over and above the terms-of-trade shocks observed typically in developing economies.
The author gratefully acknowledges the comments received from a referee of this journal.
Inflation (proportionate changes in a price index) and relative prices of goods are intrinsically linked (Parks 1978; Fischer 1981). The existing literature investigates the way inflation affects the economy through its impact on relative price variability. An unanticipated demand shock may lead to asymmetric price adjustments by firms—as all the firms may not find it optimal to revise output prices (Calvo 1983)—leading to relative price variability. Hence demand shocks that lead to inflation, may primarily come from relative price variability. The effect is more pronounced when shocks are large (Ball and Mankiw 1995).
In a flexible inflation targeting regime, the central bank optimally responds to inflation shocks by minimising a social loss function comprising both output and inflation fluctuations from their desirable levels (Svensson 1999; Walsh 2010). Further, terms-of-trade (ToT) shocks (which is a variable other than the usual output and inflation gap) are an important determinant of optimal monetary policy where the economies have heterogeneous sectors (like India)—say agricultural and manufacturing sectors (Aoki 2001; Ghate et al 2016).
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