Effects of Monetary Policy Shocks on Farm Prices and Exchange Rate

Abstract

The farm financial crisis following the monetary regime change in the early 1980s of the U.S. was an important historical episode that made many economists reevaluate the effect of macroeconomic events such as monetary policy shocks on agricultural markets. From the experience of the farm financial crisis, many economists realized that farm prices are affected not only by shocks in agricultural markets but also by shocks in monetary policy and macroeconomic condition. Since then, many researchers investigated the effects of monetary shocks on farm prices. In contrast with the traditional view based on neutrality of money and flexible prices, the overshooting theory is developed, which suggests that the short-run responses of farm prices overshoot the long run level in the presence of a sticky non-farm price under monetary policy shocks and thus the real farm or relative prices may change in the short-run in the presence of monetary policy shocks. Many empirical studies on the effects of monetary policy shocks on farm prices, especially in the U.S., were conducted but the empirical evidence was mixed. In addition, the studies on emerging/developing countries such as Korea are very rare. To document further evidence and help to resolve the controversy in the literature, this study empirically analyzes the effects of monetary policy shocks on farm prices in the U.S and South Korea (for the post Asian crisis period in which many regulations in agricultural markets are deregulated.) by applying a recently developed empirical method in the VAR framework. This study identifies monetary policy shocks by imposing sign restrictions on impulse responses. Further, this study analyzes the effects on exchange rate and farm prices together, differently from past studies that focus on either exchange rate or farm prices. The empirical model for the U.S. follows the detailed specifications of Uhlig (2005) that also analyzes the effects of monetary policy shocks in the U.S. In addition to farm prices and the exchange rate, the key macro variables such as product, non-borrowed reserves, the Federal Funds rate, the price level, and a price variable that is likely to reflect the expectation on the price level are included in the model. To identify negative interest shocks, we use the following sign restrictions on impulse responses. The Federal Funds rate increases, the price level and the price variable decrease, and non-borrowed reserves decrease. The predictions of most theories on the effects of monetary policy shocks are consistent with these effects. The empirical model for Korea incorporates small open economy features, as suggested by Kim and Lim (2015). The key macro variables such as production, the price level, the short-term interest rate, and monetary base are included in addition the exchange rate and to farm prices. Furthermore, the U.S. Federal Funds rate, the U.S. output, the U.S. price level, and VIX are included as exogenous variables in the empirical model to reflect the small open economy feature in which US macroeconomic condition and international financial market condition are important factors. The following sign restrictions, that are similar to those used in the U.S. model, are imposed. The short-term rate increases, the price level and monetary base decrease. The main empirical results for the U.S. can be described as follows. First, contractionary monetary policy shocks have significant negative effects on real farm prices, which suggest that farm prices respond to monetary policy shocks more than the general price level. This is against the traditional view based on the neutrality of money assumption. Second, the effects of monetary policy shocks on farm prices are stronger than the effects of monetary policy shocks on exchange rate. The former is as large as or greater than the latter even in the floating exchange rate regime period. The result is interesting since exchange rate is often thought of as a variable that is substantially affected by monetary policy shocks. Third, farm price dynamics under monetary policy shocks show delayed overshooting as exchange rate dynamics under monetary policy shocks do. These results imply that the equilibrium condition between the interest rate and the expected return on holding farm products and the uncovered interest parity (UIP) condition do not hold conditional on monetary policy shocks. The main empirical results for Korea are as follows. First, (contractionary) monetary policy shocks have significant negative effects on real farm prices, which suggest that farm prices respond to monetary policy shocks more than the general price level. This is against the traditional view based on the neutrality of money. The effect on real farm prices in Korea is less persistent than in the U.S. This result may be explained by farm price stabilization policy and strong regulation in farm prices in Korea. Second, the effects of monetary policy shocks on farm prices are far stronger than the effects of monetary shocks on exchange rate. This tendency is even more clear in Korea than in the United States. This result may be explained by the fact that exchange rate is less flexible in Korea than in the United States. Farm price responses are short-lived and not inconsistent with the overshooting theory. The results in this study suggest that macroeconomic shocks such as monetary policy shocks can affect farm prices significantly and generate volatility in farm prices, not only in the U.S. but also in Korea. Although micro factors mostly explain farm price dynamics, considering macro factors can also helpful in understanding farm price dynamics and implementing farm price stabilization policies. However, the current study has a limitation in that it does not explicitly consider various important factors of farm price determination, such as weather and micro factors.