Terms of trade shocks and monetary policy in India

  • Food grain procurement by the Indian government can cause terms of trade shocks between sectors. This has implications for setting monetary policy.
  • We developed a multi-sector model to understand the effects of shocks to procurement and productivity in the grain sector on terms of trade and monetary policy.
  • We found that procurement weakens monetary policy transmission and welfare losses increase with the level of procurement. The central bank’s response to a terms of trade shock needs to be stronger.
  • Our model can be extended to other emerging markets and developing economics.

Understanding monetary policy design in emerging markets and developing economies is a growing area of research. One aspect that is missing is how distortions in the agricultural sector translate into output and inflation dynamics, and the implications this has for setting monetary policy. In particular, central banks in emerging markets often grapple with understanding the inflationary impact of a shock emanating from the agriculture sector.

We identified the mechanism through which changes in the terms of trade caused by food grain procurement by the government affect the economy. We also compared the transmission of a positive procurement shock with a negative productivity shock. We consider these two cases because they typify the kind of shocks experienced by the Indian agricultural sector. A positive procurement shock might be the result of an upward increase in government procurement of grain. A negative productivity shock could be caused by a poor monsoon.

We found that a positive procurement shock leads to higher inflation, a change in the sectoral terms of trade, and increased output because of a change in the sectoral allocation of labour. Labour is reallocated away from the manufacturing and the vegetable sector. The result of a negative productivity shock is higher inflation and reduced output, and labour is reallocated towards the manufacturing and vegetable sectors.

We show that procurement weakens monetary policy transmission and welfare losses increase with the level of procurement. The central bank’s response to a terms of trade shock therefore needs to be stronger.

Outputs