Which Nominal Anchor for Commodity Exporting Countries?

One of the big economic challenges facing major commodity exporters (mainly small developing countries) is the management of risks from random fluctuations in their export prices. Usually these prices are denominated in one of the major currencies, such as the US dollar and the Euro, and so frequent movements in exchange rates alone (such as the depreciation of the dollar against the Euro seen in recent years) can also be problematic.

In CEPR Policy Insight No. 25, Jeffrey Frankel (Harvard Uni.) proposes a solution: pegging the domestic currency only to the export price. For e.g., for a gold exporting country, the proposal would be that, when the dollar price of gold increases in the world market, the domestic currency should appreciate against the dollar (that is, monetary policy should be tighter) and vice versa. Commodities may be viewed as assets (like physical capital), thus in a sense, Frankel favors monetary policy that responds to asset prices, an issue that is still under debate in the academic and policy arenas. Moreover, the proposal is in sharp contrast to the strategy of inflation targeting (IT) adopted by many advanced and emerging-market economies. As a nominal anchor, IT involves setting an inflation target based on the consumer price index (one component of which is import prices). For a defense of the IT strategy, see Lars Svensson's (Princeton Uni.) comment on Frankel's proposal.