Monday, December 5, 2011

The Relative Volatility of Commodity Prices: A Reappraisal

Are the international prices of primary commodities more volatile than those of manufactured goods? This question has important implications for macroeconomic and development policies, and the conventional wisdom expressed in academic and policy circles is that they are. The policy literature is replete with prescriptions for economies to cope with the volatility of commodity prices, ranging from prescribed investments in financial hedging instruments such as commodity futures to fiscal stabilization rules to help reduce the pass through of commodity price volatility into domestic economies. A recent example is the World Bank’s 4 billion dollar contribution to a joint fund launched in June 21, 2011 with J.P.

Morgan to help developing countries invest in commodity-price hedging instruments.In fact, the concern over the impact of commodity price volatility on developing countries has also led the World Bank to argue that economic diversification away from commodities should be a priority for these countries even if this requires industrial policies. Indeed, there are good reasons to expect that commodity prices are relatively volatile. One is that commodities, by definition, are goods that retain their qualities over time, which allows economic agents to use them as financial assets. This might be the case, for example, of gold and other commodities whose prices tend to rise amidst global financial uncertainty.

Caballero et al. (2008), for example, argued that the volatility of commodity prices could be due to the lack of a global safe asset (besides the U.S. Treasury bills). An earlier literature argued that commodity price volatility was fueled by stockpiling policies to secure access to food or fuel during times of relative scarcity (Deaton and Laroque 1992). These mechanisms add price volatility because of unavoidable asymmetric stockpiling rules; that is, the stockpile of commodities cannot be negative. Yet another potential explanation is the lumpiness of exploration investments in mining, which results in inelastic supply in the short run (Deaton and Laroque 2003). Finally, more traditional economic analysis of the effects of random demand shocks on homogeneous (i.e., commodities) and differentiated goods (i.e., manufactured products) also suggests that the resulting price volatility of the latter would tend to be lower as producers of differentiated products could maximize profits by reducing supply in response to negative demand shocks.

However, there are also good reasons to expect a higher volatility of differentiated manufactured goods. Product innovation and differentiation itself might contribute to price volatility by producing frequent shifts in residual demand for existing varieties. Indeed, the trade literature has acknowledged the wide dispersion in unit values of within narrowly defined product categories in the United States import data at the 10-digit level of the Harmonized System (HS) (Schott 2004). Also, the demand for differentiated products might be more unstable with respect to household and aggregate income shocks than that for basic commodities. For instance, the demand for fuel and food might decline proportionately less than the demand for automobiles or electronics when incomes fall.

World Bank. Author/Editor: Arezki, Rabah ; Lederman, Daniel; Zhao, Hongyan.December 01, 2011.Working Paper No. 11/279

The Relative Volatility of Commodity Prices: A Reappraisal.