International Review of Economics and Finance 29 (2014) 372–379

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International Review of Economics and Finance

j ourna l homepage: www.e lsev ie r .com/ locate / i re f

Monetary policy and price dynamics in a commodity futures market

Meng-Yi Tai a, Chi-Chur Chao b,⁎, Shih-Wen Hu c,d, Ching-Chong Lai c,e, Vey Wang c

a Department of Applied Economics, Fo Guang University, Yilan, Taiwanb Graduate School of Business, Deakin University, Melbourne, Australiac Department of Economics, Feng Chia University, Taichung, Taiwand College of Finance and Economics, Ling Tung University, Taichung, Taiwane Institute of Economics, Academia Sinica, Taipei, Taiwan

a r t i c l e i n f o

⁎ Corresponding author.E-mail addresses: mytai@mail.fgu.edu.tw (M.-Y. Ta

wangwei@fcu.edu.tw (V. Wang).1 Parsley (1995) pointed out the difference between

effect exists.2 Also see studies in In and Mount (1994).3 See Food and Agriculture Organization of the Unit

1059-0560/$ – see front matter © 2013 Elsevier Inc. Ahttp://dx.doi.org/10.1016/j.iref.2013.06.007

a b s t r a c t

Article history:Received 16 January 2013Received in revised form 26 June 2013Accepted 26 June 2013Available online 4 July 2013

Using a general-equilibrium framework, this paper examines the price dynamics of a monetaryshock for a small open economy with commodity spot and futures markets. The agriculturalspot price can fall by exhibiting a mis-adjustment at the instant of the announcement of theincrease in the money supply under certain conditions. Accordingly, the price of agriculturalfutures can fall at the instant of the policy announcement but it eventually increases to a newequilibrium level when the policy is implemented.

© 2013 Elsevier Inc. All rights reserved.

JEL classification:E30Q11

Keywords:Commodity spot priceFutures priceMonetary shock

1. Introduction

Since the pioneering work of Dornbusch (1976), substantial research has studied price and exchange rate dynamics of themonetary policy in commodity spot markets, but with less attention on the futures markets.1 The analysis has been extended to theagriculturalmarkets. Frankel andHardouvelis (1985) and Barnhart (1989) find that the announced change inmoney supply is crucialin determining the evolution of agricultural spot prices. In addition, Bessler (1984), Taylor and Spriggs (1989), Lapp (1990) andSaghaina, Reed, and Marhant (2002) empirically estimate the impacts of monetary policy on agricultural and manufactured prices.2

According to the 2009 report of theOECD–FAO Agricultural outlook,3 average crop prices in 2009–2018 are projected to be 10–20%higher in real terms relative to 1997–2006. As indicated in Fig. 1, rise in agricultural prices are however particularly significant in theagricultural futures. For example, the price of wheat futures rose to US$12.24 a bushel in March 17, 2008, which was the first time itexceeded US$10, with the increase by 36% in the Chicago Board of Trade (CBOT).

In general, changes in commodity prices are often caused by natural and political factors, which are rather difficult to predict inadvance. For hedging the associated risks, markets for commodity futures have therefore developed. Agricultural futures are theoldest one for avoiding sudden price falls or rises because of bumper crop or harvest shortage. In addition, speculators can reap profitsby engaging in arbitrages in the futures markets. Johnson (1960) took the lead in the study of futures hedging and speculations.

i), chichurchao@gmail.com (C.-C. Chao), swhu@fcu.edu.tw (S.-W. Hu), cclai@econ.sinica.edu.tw (C.-C. Lai),

the effects of anticipated futures exchange rate shocks on domestic and import prices when the reputation

ed Nations (FAO) and Organization for Economic Cooperation and Development (OECD).

ll rights reserved.

0

100

200

300

400

500

600

700

800

900

1000

unit:

cen

t/bus

hels

Year

Wheat futures price

Soybean futures price

Corn futures price

Fig. 1. Selected agricultural futures price of CBOT.

373M.-Y. Tai et al. / International Review of Economics and Finance 29 (2014) 372–379

Elfakhani and Wionzek (1997) later analyzed the efficiency of Canadian canola and American soybean oil futures markets during1981–1987 and 1988–1993. On the other hand, Bond (1984) was the first one to use a partial equilibriummodel to examine interestrate shocks on futures prices. However, general-equilibrium analysis on the impacts of monetary shocks on price and exchange ratedynamics in both spot and futures markets, with a special attention on the agricultural futures, remains deficit.

Based on a small open, general-equilibrium framework with goods, money, bonds and foreign exchange markets, this paperinvestigates the impacts of the announcement of a monetary expansion on the price dynamics in commodity spot and futures marketsas well as on the dynamic adjustments of the exchange rate for the economy. In particular, the phenomena for overshooting andmis-adjustments of the spot and futures prices can occur and the conditions of themwill be identified and explained. These results thenprovide a vivid illustration for the fluctuations of commodity prices followed by the announcement of the change in themoney supply.

The paper is organized as follows. Section 2 outlines the structure of the general-equilibrium framework of the commodity, moneyand foreign exchange markets, while Section 3 characterizes the steady-state equilibrium and the dynamic behavior of the economyassociated with monetary shocks. Section 4 provides conclusions.

2. The model

We consider a small-open, general-equilibrium economy with a commodity futures market a la Bond (1984). The countryproduces two goods: manufactured product Ym and agricultural product Yc. Domestic manufactured products are traded goods,and domestic residents treat both domestic manufactured products and foreign manufactured products as perfect substitutes.Domestic residents hold four types of assets: money, domestic bonds, foreign bonds and agricultural product. Domestic bonds andforeign foreign exchange are treated as perfectly substitutable assets by the public. Accordingly, perfect capital mobility is presentin the international capital market.

The home economy can be described by the following equations with lower-letter variables expressed in logarithms, exceptfor the domestic and foreign interest rates, i and i⁎:

whereFurtherepres

4 See

−θ pc−pmð Þ þ β pfc−pc−k−i� �

¼ μ pc−pmð Þ; θ N 0;β N 0; μ N 0 ð1Þ

β pfc−pc−k−i� �

¼ η _pc− pfc−pc� �h i

;β N 0;η N 0 ð2Þ

eþ p�m ¼ pm ð3Þ

m−p ¼ −λiþ ϕy;λ N 0;ϕ N 0 ð4Þ

i ¼ i� þ _e ð5Þ

p ¼ αpc þ 1−αð Þpm;0 b α b 1 ð6Þ

pc and pm are the domestic agricultural and manufacturing prices, while pcf denotes the futures agricultural price.

rmore, pm⁎ is the foreign manufacturing price, p is the domestic general price level, e denotes the exchange rate, ments money supply and y is real output. Note that k expresses the storage cost of the agricultural product. In addition, theer a variable represents the rate of change with respect to time.

dot ov

Eq. (1) is the equilibrium condition for the agricultural spot market, which specifies that the sum of consumption demand andasset demand is equal to its supply in the spot market. The consumption demand for agricultural product is a decreasing functionof the relative price between the spot agricultural and manufactured prices,4 while the asset demand is an increasing function of

Appendix A for derivations.

374 M.-Y. Tai et al. / International Review of Economics and Finance 29 (2014) 372–379

the relative return between agricultural futures and bonds.5 On the other hand, the supply of agricultural products dependspositively on the relative price between the agricultural and manufactured prices in the spot market.6

Eq. (2) is the equilibrium condition for the agricultural futures market. Following Bond (1984), the supply of agriculturalfutures market is equal to the speculator's demand of the agricultural futures market. Left side of the equal sign is the supply ofthe agricultural futures market. It specifies that the supply of futures market by inventory dealers, which will be equal to the levelof inventory demand.7 Right side of the equal sign is the demand of the agricultural futures market, which comes from thespeculators demand, and η represents the speculative degree.

Eq. (3) states the law of one price, as the prices of the traded manufacturing goods are identical domestically and abroad.Eq. (4) describes the domestic money market, in which the demand for the real money balances is a decreasing function of thenominal interest rate and is an increasing function of real output.8 With the assumption of perfect capital mobility, Eq. (5) statesthat the interest rate parity holds. Finally, Eq. (6) defines the general price level as being a weighted average of the domesticagricultural and manufactured prices.

First of all, from Eqs. (1)–(4), and (6) we can derive the following expressions:

where

5 See6 See7 See8 Rea9 In a

addition10 The11 Wemacroe12 The

i ¼ 1λ

ϕy−mþ αpc þ 1−αð Þeþ 1−αð Þp�m� � ð7aÞ

pfc ¼θþ β þ μ

βþ α

λ

� �pc−

θþ μβ

−1−αλ

� �eþ p�m� þ kþ ϕ

λy− 1

λm− 1

βgc: ð7bÞ

Thehome economy, described in Eqs. (1)–(6), can be expressed by the dynamic system involving two state variables, pc and e:

_pc_e

�¼ Ω1 Ω2

Ψ1 ψ2

�pce

�þ Ω3m

Ψ3m

�ð8Þ

Ω1 ¼ ∂ _pc∂pc

¼ λ θþ μð Þ β þ ηð Þ þ αβηλβη

N 0

Ω2 ¼ ∂ _pc

∂e ¼ −λ θþ μð Þ β þ ηð Þ−βη 1−αð Þλβη

Nb

0; if λ θþ μð Þ β þ ηð ÞbNβη 1−αð Þ

Ω3 ¼ ∂ _pc

∂m ¼ − 1λ

b 0

Ψ1 ¼ ∂ _e∂pc

¼ αλ

N 0

Ψ2 ¼ ∂ _e∂e ¼ 1−α

λN 0

Ψ3 ¼ ∂ _e∂m ¼ − 1

λb 0:

It is noted that Ω2 can be either positive or negative, depending mainly upon the relative magnitude between the price effectof agricultural products and the speculative degree of investors. Nonetheless, empirical studies find that the price elasticities ofagricultural demand and supply, measured by θ and μ, are relatively small.9 We thus consider the case that Ω2 N 0 in the followinganalysis.10

We turn next to the long-run properties of the system. In the long-run equilibrium, _pc ¼ _e ¼ 0, and the stationary values ofthem are denoted by pc and e. From Eqs. (7a), (7b), and (8), we obtain the following results11:

∂pc

∂m ¼ ∂e∂m ¼ ∂pf

c

∂m ¼ 1;∂i∂m ¼ 0: ð9Þ

Eq. (9) reveals that money is neutral in the long run because a rise in the money supply proportionally increases the exchangerate and the prices of agricultural spot and futures, while leaving the interest rate unchanged in the long run. These results aresimilar to those obtained in Lai, Hu, and Wang (1996).12

Appendix B for explanations.Appendix C.Appendix D for the detail.l output is defined as: Y = (PcYC + PmYM)/P, where y = ln Y, pc = ln Pc, pm = ln Pm, and p = ln P.nd Mount (1994), and Swinton and Thomas (2001) suggest that the price elasticities for demand and supply of agricultural products are 0.13 and 0.29. In, Parkin (2010) points out that the food demand price elasticity is 0.12 in the US. Similar patterns are found in Canada and France.analysis on the case that Ω2 b 0 is available upon request.can consider the case with the exogenous interest rate and endogenous money supply, and then analyze the effects of a change in the interest rate onconomics variables. We are grateful to an anonymous referee for bringing this point to us.model in Lai et al. (1996) is a closed economy model without commodity futures.

375M.-Y. Tai et al. / International Review of Economics and Finance 29 (2014) 372–379

We now proceed to analyze the dynamic behavior of the economy. By letting s be the eigenvalues of the dynamic system, thecharacteristic equation for Eq. (8) is:

wheregiven

13 ∂pc∂e

��14 The

Thisslop

s2− Ω1 þΨ2ð Þsþ Ω1Ψ2−Ω2Ψ1ð Þ ¼ 0: ð10Þ

Let s1 and s2 be the two characteristic roots of the dynamic system that satisfies Eq. (10). We then have the followingrelationship:

s1 þ s2 ¼ Ω1 þΨ2 N 0 ð11aÞ

s1s2 ¼ Ω1Ψ2−Ω2Ψ1 ¼ θþ μð Þ β þ ηð Þλβη

N 0: ð11bÞ

Eqs. (11a) and (11b) imply that the two characteristic roots must have positive signs, yielding two jump variables. This meansthat the economy is globally unstable. For expository convenience, we assume that 0 b s1 b s2. It follows from Eq. (8) that thegeneral solution for pc and e can be expressed as:

pc ¼ pc þ A1es1t þ A2e

s2t ð12Þ

e ¼ e þ s1−Ω1

Ω2A1e

s1t þ s2−Ω1

Ω2A2e

s2t : ð13Þ

A1 and A2 are undetermined coefficients. Furthermore, from Eq. (8), the slopes of the equilibrium loci _pc ¼ 0 and _e ¼ 0 areby:

∂pc∂e

����_pc¼0

¼ −Ω2

Ω1b 0 ð14Þ

∂pc∂e

����_e¼0

¼ −Ψ2

Ψ1b 0: ð15Þ

Eqs. (14) and (15) show that both of the _pc ¼ 0 and _e ¼ 0 loci are downward sloping, but the _pc ¼ 0 locus is more flat than the_e ¼ 0 locus.13

Let us define theUU1 andUU2 lines as being associatedwith A2 = 0 and A1 = 0 for two unstable branches, which represent the pairsof pc and e that satisfy Eqs. (12) and (13). From Eqs. (12) and (13), the slopes of UU1 and UU2 lines are respectively given by14:

∂pc∂e

����UU1

¼ Ω2

s1−Ω1b 0 ð16Þ

∂pc∂e

����UU2

¼ Ω2

s2−Ω1N 0: ð17Þ

Based on Eqs. (14)–(17), we can plot the phase diagram in Fig. 2, with the adjustment directions by the arrows. Since the linesUU1 and UU2 represent the two unstable branches, the trajectories start from the UU1 path and then asymptotically diverge fromthe UU2 path.

3. Dynamic adjustments

We are now ready to address dynamic adjustments of the two state variables, pc and e, and the consequent impact on theagricultural futures price pcf in response to an expansion in themoney supply. At the outset,we define 0− and 0+ to denote the instantbefore and after the policy announcement, and T− and T+ as denoting the instant before and after the policy implementation,respectively.

_e¼0−∂pc∂e

��_pc¼0 ¼ −s1s2

Ψ1Ω1b 0:

denominator of the UU1 line multiplied by the UU2 line is:

∂pc∂e

����UU1

" #∂pc∂e

����UU2

" #¼ −Ω2

Ψ1b 0:

suggests that one of the slopes of the UU1 and UU2 lines is positive. Moreover, since 0 b s1 b s2, the UU1 line is downward sloping while UU2 is upwarding.

2UU

1UU

0cp

e

cp

0e

)(c

)(b

)(a

)(d

Fig. 2. Phase diagram.

376 M.-Y. Tai et al. / International Review of Economics and Finance 29 (2014) 372–379

In order to investigate the effect of this monetary supply shock on the agricultural futures price (pcf), we obtain the differentialequation for pcf from Eq. (8) as:

and th

15 Therate mis16 Aokmis-adj

_pfc ¼

θþ β þ μβ

þ αλ

� �_pc−

θþ μβ

−1−αλ

� �_e− 1

λ_m ð18Þ

us the equilibrium loci of the _pfc ¼ 0 line are given by:

∂pc∂e

����_pfc¼0

¼ θþ β þ μð Þ=β þ α=λð Þ½ �Ω1

θþ β þ μð Þ=β þ α=λ½ �Ω1− θþ μð Þ=β− 1−αð Þ=λ½ �Ψ1⋅∂pc∂e

����_pc¼0

− θþ μð Þ=β− 1−αð Þ=λ½ �Ψ1

θþ β þ μð Þ=β þ α=λ½ �Ω1− θþ μð Þ=β− 1−αð Þ=λ½ �Ψ1⋅∂pc∂e

����_e¼0

:

ð19Þ

When the price elasticities of demand and supply of agricultural products are relatively small (i.e., Ω2 N 0), the slope of the_pfc ¼ 0 line is negative. Moreover, the _pf

c ¼ 0 line lies between _pc ¼ 0 and _e ¼ 0 lines, as illustrated in Fig. 3 with the slope of UU2

being greater than 1.15

In Fig. 3, the initial equilibrium, the intersection point between _pc ¼ 0 m0ð Þ and _e ¼ 0 m0ð Þ, is at Q0−, and the initial agricultural

spot price and exchange rate are pc0− and e0−, respectively. Upon a permanent monetary shock, both _pc ¼ 0 m0ð Þ and _e ¼ 0 m0ð Þ

shift rightwards to _pc ¼ 0 m1ð Þ and _e ¼ 0 m1ð Þ, yielding a new equilibrium pc1 and e1 at point Q1. Since money is neutral in the longrun, both points Q1 and Q0 should be located on the 45° line going through the origin. This gives the dynamic adjustment alongpath a when the policy is announced. Specifically, at time 0+, the economy jumps from Q0

− to a point on path a, and the range ofthe jump depends on the time lag between the policy announcement at time 0 and its implementation at time T. For a longerimplementation time, the economy jumps from point Q0

− to Q0+ when the policy is announced, in which the agricultural spot price

decreases from pc0− to pc0þ and the exchange rate rises from e0− to e0

+ initially. The economy then follows the path to its newstationary equilibrium at point Q1 when the policy is implemented. Thus, the short-run movement in agricultural spot priceappears to be mis-adjusted as pointed out in Aoki (1985).16 However, when the time lag between the policy announcement andits implementation is shorter, the economy jumps from the original equilibrium at point Q0

− to a new point at Qþ′

0 , which yields aundershooting in the agricultural spot price. Finally, for a limiting case of T = 0, the policy announcement becomesunanticipated. In this situation, the economy jumps from point Q0

− to Q1 immediately.Moreover, the time paths of the prices of agricultural futures are illustrated in Fig. 4, in which the trajectories (I) and (II)

indicate the adjustment paths under the shorter and the longer implementation time. In particular, when the implementationtime is longer, the price of agricultural futures falls at the instant of the policy announcement because the agricultural spot price ismis-adjusted. Nonetheless, no matter in which the price of agricultural futures rises or falls at the instant of the policyannouncement, its long-run price will increase to a new equilibrium point at the instant of the policy implementation at time T+.

exchange rate can be mis-adjusted for the case that the slope of UU2 is less than 1. Grossmann and Orlov (2012) investigate the volatility of spot exchangealignment.i (1985) does not include an analysis of the agricultural spot and futures markets, but finds that the economy would exhibit a time path characterized by austment if a decrease in output is announced.

2UU

1UU

)(0 0mpc

e

cp

)(0 0me

)(0 1me

)(0 1mpc

0e 0e 1e

0cp

0cp

1cp

045

1Q

0Q

0Q0Q

)(a

0fcp

Fig. 3. Price dynamics of monetary expansion.

t

fcp

fcp 1

fc

p0

fc

p0

fc

p0

1T

)(I

)(II

2T

Fig. 4. Time paths of agricultural futures prices.

377M.-Y. Tai et al. / International Review of Economics and Finance 29 (2014) 372–379

4. Conclusions

This paper has analyzed the price dynamics of a monetary shock for a small open economy with commodity spot and futuresmarkets.17 We have found that the agricultural spot price can fall by exhibiting a mis-adjustment at the instant of theannouncement of the increase in the money supply when the price elasticities for the demand and supply of agricultural productsare relatively small or the speculative degree for agricultural futures is relatively large. Accordingly, the price of agriculturalfutures falls at the instant of the policy announcement but it eventually increases to a new equilibrium level when the policy isimplemented.

17 We thank a referee for pointing out that a decrease in the weight α on the agricultural price in Eq. (6) leads to an increase in real money supply in Eq. (4).

378 M.-Y. Tai et al. / International Review of Economics and Finance 29 (2014) 372–379

Acknowledgments

The authors are indebted to two anonymous referees for constructive suggestions and insightful comments. The researchunderlying this paper is supported by the National Science Council (Project No. NSC 98-2410-H-035-013). Any errors orshortcomings are the authors' responsibility.

Appendix A. Consumption demand for agricultural spot and manufacture markets

Consumers demand for agricultural and manufactured goods, Dc and Dm, to maximize utility subject to the budget constraint:Max U(Dc, Dm) s.t. PcDc + PmDm = Λ, where Pc and Pm are the domestic agricultural and manufacturing prices, and Λ is nominalincome. All capital letter variables are in natural numbers. By assuming that the utility function is quasi-linear, U(Dc, Dm) =Dm + u(Dc), we obtain: Dc = Dc(Pc, Pm) and Dm = Dm(Pc, Pm, Λ). Since the demand function for Dc is homogeneous of degree zerowith respect to the arguments, it can be then expressed in logarithms: dc = − θ(pc − pm) as given in Eq. (1).

In Eq. (3), foreign demand for the manufactured good is: ψ(pm⁎ + e − pm), which depends on the relative price between foreignand domestic manufactured goods. We assume that capital is perfect mobility, i.e., domestic and foreign manufactured goods areperfect substitute (ψ → ∞), foreign demand for the manufactured good is degraded as: e + pm⁎ = pm, as stated in Eq. (3).

Appendix B. Asset demand for agricultural spot (i.e. supply of agricultural futures)

Let Pc and Pcf denote the agricultural spot and futures prices. One unit of domestic currency can buy 1/Pc units of agricultural

product as inventory and then sell them in the futures market for receiving Pcf/Pc units of currency. This gives the rate of returnon agricultural asset: (Pcf − Pc)/Pc − k, where k is the storage cost. Since in equilibrium agricultural spot and domestic bondsare perfect substitutes to domestic residents, asset demand for agricultural spot is an increasing function of its relative return:(Pcf − Pc)/Pc − k − i ≈ pc

f − Pc − k − i, where pcf = ln Pcf and Pc = ln Pc.

Appendix C. Supply of the agricultural spot market

In the supply side of the agricultural spot market, we pursuit to maximize the total revenue under the production ofagricultural and manufactured products: Max PmSm + PcSc s. t. F(Sc, Sm) = 0, where Sc and Sm indicate the supply functions ofagricultural and manufactured products, respectively, and F(.) denotes the production possibilities frontier. The first-orderconditions give: dSm/dSc = −Pc/Pm. Hence, Sc is the function of Pc/Pm, which can be expressed in logarithms in Eq. (1).

Appendix D. Demand for agricultural futures

Following Bond (1984), the equilibrium condition for the agricultural futures market is stated in Eq. (2), in which the supply ofagricultural futures is equal to the demand from speculators. Since the supply of agricultural futures is equal to the asset demandof agricultural spot (see Appendix B), here we focus on the demand side of the agricultural futures market. For speculators, theexpected return of holding agricultural futures is: pce − pc

f , where pce is the expected agricultural spot price in the next period.

Thus, the demand function for agricultural futures is: G = η(pce − pcf), where η is the degree of speculations, and it can be further

expressed by:

under

18 This

G ¼ η pec−pc�

− pfc−pc� �h i

¼ η _pc− pfc−pc� �h i

perfect foresight.18

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