Heterogeneity and the Role of Commodity Price Shocks

Abstract

Commodity prices are widely viewed as a major source of business-cycle fluctuations in emerging-market economies (EMEs). This view is largely based on representative agent models, where agents behave according to the permanent income hypothesis (PIH). However, recent empirical evidence points to large deviations from PIH (Bracco et al., 2021) . Do these deviations from PIH behavior affect the importance of commodity price shocks for EME’s business cycles? To answer this question I first show analytically that deviations from PIH can matter via two channels. On the one hand, hand-to-mouth agents (i.e. those who violate PIH) amplify the income effect of commodity price shocks in the short-run and dampen it in the long-run. On the other hand, they dampen the indirect interest-rate effect of these shocks. I then estimate a structural model to quantitatively explore the effect of PIH deviations on the importance of commodity price shocks as business-cycle drivers. The model is a standard small open economy model with two agents, and is estimated to match data from Brazil, Chile, and Colombia. Using variance decompositions I show that hand-to-mouth agents increase the importance of commodity price shocks for output fluctuations, and can increase (decrease) the importance of commodity price shocks for consumption in the short-run (long-run). Finally, I quantify the importance of two mechanisms in generating these results. First, the indirect interest rate effect is a relevant transmission channel for commodity price shocks, but it does not appear to be dampened by hand-to-mouth agents. Second, wealth effects on labor supply account for most of the amplification of hand-to-mouth agents on income and consumption.