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Should a Central Bank React to Food Inflation?

Evidence from an Estimated Model for Chile
William Ginn∗ Marc Pourroy†‡

Abstract
We examine whether food price shocks are a major source of macroeconomic fluctuations. We estimate
a small open economy DSGE model using an alternative Taylor rule applied to Chilean data. The empirical
evidence suggests that food inflation played a non-trivial role in shaping Chile’s de facto monetary policy
actions. Consistent with its commitment to price stability, the central bank increases the policy rate in
reaction to food inflation. Despite an immediate monetary policy reaction to a food price shock, the
policy rate gradually tapers off. This is due to a second-round effect on non-food inflation propagated
by the food price shock. A main finding is that monetary policy that targets headline inflation is welfare
improving.

JEL Classification: E52, E60, E30, E32.

Keywords: Monetary Policy, Commodities, Food prices, DSGE Model.

Highlights:

– Food inflation is a challenge for central banks in middle income countries

– We estimate a DSGE model via Bayesian methods using Chilean data
– Food prices are found to play a role in the interest rate rule
– Despite a policy reaction to a world food price shock, the shock generates second-round effects
– Based on an alternative Taylor rule, headline inflation targeting is welfare improving

∗ Adidas, Economist/Data Scientist, Germany. William.Ginn.OBA@said.oxford.edu

† University of Poitiers, France. Marc.Pourroy@univ-poitiers.fr
‡ The authors would like to thank Jürgen Kahler, Christian Merkl, Dramane Coulibaly and Anne-Gael Vaubourg. We are

especially grateful to the editor, Sushanta Mallick, and three anonymous referees for their thoughtful comments.

© 2020 published by Elsevier. This manuscript is made available under the Elsevier user license
https://www.elsevier.com/open-access/userlicense/1.0/
1 Introduction
Since the early 2000s, numerous spikes in global food inflation have served to remind us of the volatile and
persistent food prices in the 1970s, characterized as an international crisis. Elevated food inflation inevitably
make monetary policy subject to more uncertainty, particularly in low- and middle-income economies, consid-
ering a sizable proportion of these households are financially constrained and the share of food expenditures
are high. An important question is, does monetary policy respond to food price shocks and how the policy re-
sponse transmits to the economy? Ultimately, the recent past rekindles the debate about what is the optimal
choice of a price index target used to conduct monetary policy.
The foregoing consensus, largely based on the novel work of Aoki (2001), posits that targeting core
inflation (which excludes volatile components from headline inflation, e.g. energy and food), as opposed to
headline inflation, is optimal since fully-flexible prices are posited as mean-reverting in the long-run and that
targeting core inflation can achieve headline price stability. Blinder and Reis (2005) estimate a Taylor rule
indicating that core inflation tracks monetary policy better than headline inflation during Greenspan’s tenure,
which they refer to as “Greenspan innovation”. Bodenstein et al. (2008) show that core inflation targeting is
welfare improving relative to headline inflation targeting in the presence of an energy supply shock. Overall,
the existing literature, as Goodfriend (2007) points out, suggests that targeting core headline inflation has
become a part of a “consensus model” of monetary policy.
Interestingly, the actual policy choice followed by most central banks falls short of the classical prescription
of the consensus model of targeting core inflation.1 While there is vast research on monetary policy, we find
it surprising there is sparse evidence whether a focus on headline or core inflation is optimal in the presence
of food price volatility. Yet a country’s de facto choice of an intermediate target is of paramount interest for
the underpinnings of macroeconomic research. Stripped to its core, a main premise why the literature tends
to side with core inflation is that volatile price shocks are transitory in nature. If a central bank were to
target headline inflation, it may respond too strongly to transitory movements in inflation. To avoid such a
pitfall, central banks should target core inflation, which is likely to be a predictor of future headline inflation
(Bullard et al., 2011).
Our contribution overlaps with three strands of literature. The first strand builds on to the perennial
debate whether targeting core inflation is optimal. We take stock of two counter-arguments. First, the recent
literature (Anand et al. (2015), Catão and Chang (2015), Pourroy et al. (2016) and Ginn and Pourroy (2019))
is at odds with the existing literature, such that the former does not necessarily find that core inflation
targeting is welfare improving. The point of departure hinges on the degree of incomplete markets and
country-specific characteristics. The existing literature is typically focused on economies with a sophisticated
and well-functioning markets (Montiel et al., 2010). Anand et al. (2015) demonstrate a contrasting view by
showing that targeting core inflation is no longer welfare improving for a developing economy in the presence
of a large share of households that are credit constrained and the share of food expenditures is high. Pourroy
et al. (2016) find headline (core) inflation targeting is optimal in low- and middle-income (high-income)
countries. Catão and Chang (2015) find that headline targeting is optimal when faced with imported food
price shocks. Ginn and Pourroy (2019) show that targeting headline inflation is welfare improving for a net-
food exporting middle-income country when faced with an international food price shock. Second, food prices
have been elevated and not necessarily mean-reverting. This implies theory no longer necessarily coincides
with evidence that headline inflation is transitory. Based on this conundrum, we find it natural to ask: is
targeting core or headline inflation optimal in the presence of elevated and persistent food prices? While
we build on the aforementioned recent literature, we develop, to our knowledge, the first Bayesian DSGE
model as an empirical extension, thus allowing us to better understand the mechanisms through which food
price volatility affects macroeconomic conditions and to evaluate monetary policy actions. We then use the
estimated model to evaluate the welfare effect of changing the central bank’s inflation target.
The second strand relates to the transmission of global food price pass-through to the domestic consumer
inflation. This area of empirical research is limited and has not necessarily achieved consensus, particularly
the existence of a second-round effect. Mallick and Sousa (2012) uncover the importance of commodity price
shocks which lead to a rise in inflation in the BRICS economies. Anand et al. (2014) and Holtemöller and
Mallick (2016) find strong pass-through from a world food price shock to core inflation in India. Ferrucci et al.
(2012) find a similar mechanism in the European Union (after controlling for subsidies). This result is also
1 Most central banks that have adopted inflation targeting officially target headline inflation (Hammond, 2012).

2
confirmed in a cross-country analysis of developing and emerging economies by Gelos and Ustyugova (2017).
Walsh (2011) finds that food inflation is higher than non-food inflation even in the long-run, and that food
price volatility could lead to second-round effects. However, Cecchetti and Moessner (2008), Al-Shawarby
and Selim (2012) and Baquedano and Liefert (2014) find second round effects to be marginal, if at all present.
The third strand relates to a sparse literature on the conduct of monetary policy to control for food
inflation. Kara (2017) finds a significant weight for food inflation in the U.S. Federal Reserve’s Taylor Rule.
Bhattacharya and Jain (2019) show that at the backdrop of food inflation, a monetary tightening may in turn
precipitate food inflation in a panel of emerging economies.
Using Chile as an empirical study, our paper contributes to a small, albeit burgeoning literature on the
conduct of monetary policy in the presence of food price volatility. Chile provides an interesting case in point
as it was one of the most affected countries with regard to food price shocks especially in the mid-2000s
(Gregorio, 2009) and is a net-exporter of food (Ng and Aksoy, 2008). As recent history has shown, Chilean
food inflation has not been mean-reverting in the long-run. Hence, empirical evidence over the recent period
and theory do not necessarily coincide (see Figure 4). In 2007, food inflation climbed to 9.6%, which spilled
in the aggregate consumer prices to the extent that aggregate inflation rate rose to 4.4%, thus exceeding the
Central Bank of Chile’s band of 4%. Food prices, rather than reverting back to historical trend, continued to
rise in 2008 somewhat unabated, resulting in higher year on year food inflation of 17% with a corresponding
aggregate inflation rate of 8.7%. Considering the sizable and elevated surge in food prices, we confront the
existing literature based on the foregoing consensus with empirical findings.
Our main results are fourfold:

Evaluating the fit of an alternative Taylor rule, the Central Bank of Chile responds to short-term
developments in food inflation;
An international food price shock is found to generate second-round effects;
While the Chilean central bank includes food prices in its policy rule, the policy reaction occurs not
only at the time of a food price shock, but also after the shock to curtail the second-round effects that
food inflation has on core inflation; and
A monetary policy response that stabilizes headline inflation provides a higher welfare gain relative to
targeting core inflation.

Overall, our results do not coincide with the current consensus that targeting core inflation yields an
optimal policy for Chile and overlooking the effect of food inflation may diminish welfare. Using an empirical
framework, we provide evidence that the Central Bank of Chile’s de facto monetary policy responds to food
inflation and that headline inflation targeting is welfare improving.

2 Monetary Policy: The Chilean Experience

Over the past decades, central banks have focused on maintaining price stability, a monetary framework known
as inflation targeting (IT).2 The Central Bank of Chile has a long history of IT and is the second country to
implement IT in September 1990. A target inflation band of 2% to 4% was announced in September 1999
to cover 2001 and the band was kept until late 2006 (Valdés, 2007). Since 2007, the Central Bank of Chile’s
objective is to target an annual inflation rate of 3% over a two year policy horizon within a band of ±1%
around the target.
According to Morandé (2002), Chile’s IT framework has evolved in two phases. The first phase began
in 1990 until September 1999, encompassing a gradual shift from high inflation to a benchmark of 3%. The
second phase can be characterized as relatively more stable period. The average inflation rate from 2000 to
2017 is 3.2%, considerably lower than the first phase (Figure 1).
Chile entered a period of prolonged price stabilization in the early 1990s with inflation below 30% to single
digit levels in 2000. According to Morandé (2002), the move to inflation targeting was somewhat accidental in
that the Central Bank was considering the inflation rate at that time and a “target for inflation fit naturally
with the price stabilization goal. . . ” (p. 5). One of the main reasons was to reduce costs of stabilization by
committing to an explicit inflation objective (Morandé (2002) and Landerretche et al. (1999)). The Chilean
2 SeeNaudon and Pérez (2017) for a discussion of the institutional set up, the decision-making process and the communication
of IT central banks.

3
 Figure 1: Chile Annual CPI Inflation (in %)

Sources: FRED (mnemonic FPCPITOTLZGCHL)

experience is unique considering this period is marked as the “world’s most gradualist” price stabilization
(Landerretche et al., 1999).
The second phase started in September 1999 when Chile abandoned its exchange rate band in favor of a
free-floating exchange rate policy. This paved the way for a fully-fledged inflation targeting policy in 2000 by
means of having a single nominal anchor.

Figure 2: Chile Exchange Rate (1999:Q1-2018:Q4)

Source: FRED mnemonic RBCLBIS (REER) and NBCLBIS (NEER).

Shaded areas indicate OECD recession dates.

The Chilean exchange rate has remained stable over the second phase (Figure 2). Since 1999, the exchange
rate has fluctuated within a 10% band, a “remarkable” period overlapping the second phase of Chilean
monetary policy management considering large swings in commodity prices (Naudon and Vial, 2016).3

Figure 3: Chile Real GDP vs. Trend

Note: data in logarithm form. The trend is based on a HP filter.

Shaded areas indicate OECD recession dates.

From 2000 to 2006, the inflation rate fluctuated between 1% to 4% (see Figure 4). Chile experienced
multiple episodes of higher inflation especially in 2007 until 2008 driven by food prices. During this period,
the Chilean monetary authorities found themselves somewhat at a crossroad between stabilizing inflation
and the output gap. On the one side, the output gap turned negative (see Figure 3), while on the other
there was inflationary pressure building due to the magnitude and persistence of food prices (see Figure
3 Claro and Soto (2013) identify two pre-announced foreign exchange rate interventions in 2008 and 2011 designed to increase
international reserves due to the strong peso.

4
1).4 According to Gregorio (2009): “By early 2007, the best estimates suggested that domestic output was
undergoing a cyclical softening phase... During the first half of 2007, even when inflation was already rising in
some economies and early signs of increases could be seen in food prices, monetary policy did not make any
significant changes; moreover, in early 2007, the Monetary Policy Rate (MPR) was reduced and the option of
reducing it again was discussed. By mid-2007, the inflationary outlook changed and monetary policy followed
suit. The MPR was raised by 100 basis points in the second half of 2007 . . .” (pp. 14-15). The MPR is the
interest rate to signal policy stance in stabilizing inflation, its evolution reflects the concerns about potential
macroeconomics effects of food inflation (see Figure 4).

Figure 4: Annual Indicators: Inflation & MPR

Sources: FRED and Central Bank of Chile. Shaded areas indicate OECD recession dates. Note: Chile’s
inflation targeting framework objective is to target an annual inflation rate of 3% (shown) from 2001 onward
within a band of +/- 1% (not shown for brevity).

3 The Model
We estimate an open economy DSGE model which incorporates a food and manufacturing sector (Catão and
Chang (2015), Anand et al. (2015), Pourroy et al. (2016) and Ginn and Pourroy (2019)). We follow Anand
et al. (2015) in modelling incomplete markets characterized with credit-constrained consumers, an attribute
common in many less-advanced economies. Following Pourroy et al. (2016), the model incorporates a two-
sector (food and non-food) and two-good (tradable and non-tradable) structure. As in Catão and Chang
(2015), food price shocks are partially explained by the international food price (e.g., Holtemöller and Mallick
(2016) and Bekkers et al. (2017)). We further assume the sector-specific domestic price and exported price
is subject to local currency pricing, which in turn allows for deviations in the law of one price (Monacelli,
2005).5 To examine whether the Central Bank of Chile targets core or headline inflation, we estimate an
alternative Taylor rule which incorporates a prior for the share of food and non-food goods. This allows us
to analyze the monetary policy actions to stabilize inflation.

3.1 Household Types

There is a continuum of households on the interval [0,1]. As in Gali et al. (2004), we incorporate household
heterogeneity (Ricardian and non-Ricardian). A share of 1−λ represent the neo-classical Ricardian household
(r), who is able to smooth consumption via trading in domestic and foreign financial markets (bonds). The
rest of the households λ are labeled non-Ricardian (n), who do not have access to trade in financial markets.
To simplify notation for the household, let i ∈ (r, n). Household member i is assumed to have the same
F M
consumption preferences for both food (Ci,t ) and manufacturing (Ci,t ) goods, combined in a CES basket:
 θ
 θ−1
1
F

θ−1
θ
1
M

θ−1
Ci,t = ϕ Ci,t
θ + (1 − ϕ) Ci,t
θ θ
(1)

4 Figure 3 is based on a HP filter, where we adopt a smoothing parameter of 1,600 since we are using quarterly data.

Furthermore, Figure 3 is consistent with Chan-Lau et al. (2010) who find the output gap turned negative in 2018.
5 There is empirical evidence that shows that exchange rate fluctuations are partially transmitted to the prices of traded goods

(e.g., Alvarez et al. (2008), Ca’Zorzi et al. (2007)) in the short-run for Chile. Furthermore, Jalil and Esteban (2011) provide
empirical evidence for Chile that the food price transmission is not complete exchange rate pass-through.

5
where ϕ relates to the share of food consumption and θ is the elasticity of substitution between food and
non-food. The CES basket can be further defined by:
" # θ θF−1
1
θFθ −1 1
  θFθ −1 F
F θF FT F,N F
Ci,t = ϕF Ci,t F + (1 − ϕF ) θF
Ci,t (2)

 −1 −1
 θ θM−1
M
1
θM MT

θM
θ
1
MN

θM M
Ci,t = ϕM Ci,t M + (1 − ϕM ) θM
Ci,t θM (3)

where θF and θM represent the elasticity of substitution between tradable and non-tradable goods in the food
and non-food sectors, respectively. The CES basket implies the following aggregate consumption price index
(CPI) per unit of consumption:
h 1

1−θ
1−θ i 1−θ
Pt = ϕ PtF + (1 − ϕ) PtM (4)

where PtF and PtM represent relative prices which can be defined as follows:
h
1−θF
1−θF i 1−θ1 F
PtF = ϕF PtF T + (1 − ϕF ) PtF N (5)
h
1−θM
1−θM i 1−θ1 M
PtM = ϕM PtM T + (1 − ϕM ) PtM N (6)
The optimal consumption for food and non-food consumption by household type:
!−θM !−θF
M F
Pi,t Pi,t
Ci,M = (1 − ϕ) Ci,t , Ci,F = ϕ Ci,t (7)
Pi,t Pi,t

The optimal tradable and non-tradable demand for food is as follows:

F,T
!−θF !−θF
FN
FT
Pi,t Pi,t‘
Ci,t = ϕF F
Ci,t,F , CtF N = (1 − ϕF ) F
Ci,t,F (8)
Pi,t Pi,t
Similarly, the tradable and non-tradable demand for manufacturing is as follows:
!−θM !−θM
MT MT
MT
Pi,t MN
Pi,t
Ci,t = ϕM M
Ci,t,M , Ci,t = (1 − ϕM ) M
Ci,t,M (9)
Pi,t Pi,t

3.1.1 Ricardian Household

Ricardian households represent optimizing agents, both inter- and intra-temporally. These households derive
utility from consumption (Cr,t ) and supply labor (Nr,t ) to the food (F) and non-food (M) sectors. These
households are indexed by sector S ∈ {F, M }. Utility is described as follows:
∞ 1+χ !
X Nr,S,t r,S
Ur,S,t = Et βt ln (Cr,S,t − hr Cr,S,t−1 ) − ψ (10)
t=0
1 + χr,S

where β t represents the subjective discount factor (0< β t <1); χr,S is the intra-temporal elasticity of substi-
tution of labor supply (χr,S > 0 ); and ψ denotes the disutility of labor supply (ψ > 0). The parameter hr
governs Ricardian household habit preferences. Habit formation is only relevant for the Ricardian household.6
?
The Ricardian household solely owns financial assets which relate to domestic (Br,S,t ) and foreign (Br,S,t )
?


bond holdings, which pays a return of (1 + it−1 ) and Θ(Bt ) 1 + it+1 , respectively. The representative Ri-
cardian agent faces the following intertemporal budget constraint:


(1 + it−1 ) Br,S,t−1 St 1 + i?t+1 Θ(Bt )Br,S,t
?
Br,S,t ?
St Br,S,t
+ + Wr,t Nr,S,t − − − Cr,S,t − ΠSr,t (11)
Pt Pt Pt Pt
where Θ(Bt ) is a country risk premium and profit is denoted ΠSr,t . The Ricardian optimization can be
formalized as follows:
6 See e.g. Coenen and Straub (2005) and Céspedes et al. (2013).

6
 ∞ 1+χ
Nr,S,t r,S
X  
LU
r,S,t = β t ln(Cr,S,t − hr Cr,S,t−1 − ψ
t=0
1 + χr,S


St 1 + i?t+1 Θ(Bt )Br,S,t?

(1 + it−1 ) Br,S,t−1
+ Λr,S,t + (12)
Pt Pt
?
St Br,S,t

Br,S,t S
+ Wr,t Nr,S,t − − − Cr,S,t − Πr,t
Pt Pt
where Λr,t represents the shadow value on the Ricardian budget constraint. Optimization yields the following
first-order conditions:

∂LU
 
r,S,t 1 t 1
: Λr,S,t = − β hr Et (13)
∂Cr,S,t Cr,S,t − hr Cr,S,t−1 Cr,S,t+1 − hr Cr,S,t

∂LU
r,S,t (1 + it+1 )
: Λr,S,t = β t Et Λr,S,t+1 (14)
∂Br,S,t πt+1
" #
∂LU


r,S,t 1 + i?t+1 Θ(Bt ) St+1
? : Λr,S,t = βEt Λr,S,t+1 (15)
∂Br,S,t πt+1 St

∂LU
r,t χr,S
: ψNr,S,t = Λr,S,t Wr,S,t (16)
∂Nr,S,t
Equations (13) and (16) represent the inter-temporal optimization relating labor supply decisions with the
marginal rate of consumption and real wage. The Euler equation is represented by equations (13) and (14).
Equations (14) and (15) represents the Euler equations for domestic and foreign bonds.
In equilibrium, equations (14) and (15) have the same return, which characterizes the standard uncovered
interest rate parity (UIP) condition. Following Schmitt-Grohé and Uribe (2003), we assume the interest rate
is a function of the world interest rate with a country risk premium, where the latter ensures stationarity
based on the net foreign asset position:
?
St Br,S,t
 
Θ(Bt ) = exp −ζ (17)
Pt Yt
?
The functional form of Θ(Bt ) is decreasing in Br,S,t . As households in the domestic economy become net-
?
borrowers (Br,S,t <0), they face paying a risk-premium above the foreign interest rate.

3.1.2 Non-Ricardian Household

The Non-Ricardian Household type is assumed to be financially constrained such that current consumption
equates to wages:
1+χ
Nn,S,tn,S
Un,S,t = ln(Cn,S,t ) − ψ (18)
1 + χn,S
The budget constraint for the representative non-Ricardian agent evolves as follows:

Pt Cn,S,t = Wn,t Nn,S,t (19)

Utility maximization yields the normal intra-temporal labor supply optimality condition:

χ
n,S Wn,t
ψCn,S,t Nn,S,t = (20)
Pt

7
3.2 Firms
There are two firms representing the food (YtF ) and non-food (YtM ) sectors, which are consumed domestically
and may be exported abroad. Firms maximize profit subject to demand and technology (labor).7
There is empirical evidence showing that exchange rate fluctuations are partially transmitted to the prices
of traded goods (e.g., Alvarez et al. (2008), Ca’Zorzi et al. (2007)) in the short-run for Chile. Furthermore,
while Chilean food inflation and international food inflation is highly correlated,8 Jalil and Esteban (2011)
provide empirical evidence that the food price transmission is not necessarily complete in the short-run. Based
on this empirical evidence, we incorporate a sector-specific law of one price gap. Hence, we incorporate an
international linkage between the domestic (PtS ) and foreign sector price (PtS? ) at the prevailing exchange
rate, i.e. PtS = et PtS? /ΨSt indexed by sector S ∈ {F, M }. Variable ΨSt corresponds with deviations in the law
of one price (Monacelli, 2005).9 Furthermore, we assume non-tradable firms are allowed to set pricing à la
Calvo (1983).
There are two types of wages, WtF and WtM , for the food and manufacturing sectors, respectively. Inter-
sectoral labor (i.e., tradable and non-tradable) is perfectly mobile and inter-sectoral wages are equivalent:

WtF = WtF N = WtF T (21)

WtM = WtM N = WtM T (22)

3.2.1 Tradable Firms

Tradable firm output is based on labor and aggregate productivity:

YtT = ATt NtT (23)

for T ∈ {F T, M T }. Tradable firms optimally allocate labor resources by minimizing cost subject to production
technology:

WtT T
Nt + ϕTt YtT − ATt NtT


minNtT (24)
Pt
where ϕTt can be interpreted as the nominal marginal cost for the respective firm. Optimization yields the
real marginal costs:

WtT
ϕTt = (25)
ATt Pt

3.2.2 Non-tradable Firms

Non-tradable is derived as follows:
YtN = AN N
t Nt (26)
for N ∈ {F N, M N }. Similar to the tradable sector, non-tradable firms optimally allocate labor resources by
minimizing costs subject to output, however there is an additional step involving pricing decisions. The first
stage consists in minimizing cost to maximize profit based on perfectly competitive factor markets which is
generalized as follows:

WtN N
Nt + ϕN YtN − AN N


minNtN t t Nt (27)
Pt
Optimization yields the real marginal costs:

WtN
ϕN
t = (28)
AN
t Pt
7 Hence, production is solely based on a labor augmenting technology (e.g., Lubik and Schorfheide (2005) and Del Negro and

Schorfheide (2009)).
8 Lee and Park (2013) find high correlation between Chilean domestic food and FAO global food inflation (0.86).
9 Note that purchasing price parity holds if ΨS is equal to unity. Our approach is similar to e.g. Medina and Soto (2005), An
t
and Kang (2011) and Poghosyan and Beidas-Strom (2011) who apply a law of one price gap via an AR(1) process.

8
 As in Schmitt-Grohé and Uribe (2005), we incorporate price stickiness à la Calvo (1983) in the second
stage such that each non-tradable firm faces an exogenous probability φN > 0 of not being able to re-optimize
its price charged from the previous period. This can be expressed in the following optimization process:
∞
( ! )
N
X
s
Pj,t N N
N Et
maxPj,t φN Ξt+s N
− mct+s Yj,t+s (29)
s=0
Pt+s
subject to sector specific demand:
!−N
N
N
Pj,t
Yj,t = YtN (30)
PtN
The pricing kernel is equivalent to the marginal utility of consumption, i.e. Ξt+s = Λr,t+s /Λr,t . Inserting the
demand (30) into the maximization process (29) simplifies the optimization from a constrained maximization
to an unconstrained one:
 !−N !−N 
∞ N N N
X P j,t P j,t P j,t
N Et
maxPj,t β s φsN Ξt+s  N − mcNt+s
 YtN (31)
s=0
Pt+s PtN PtN
N
Note that Pj,t is decided in period t and not t+1 since manufacturing firms choose the optimal price in
N
the current time which will occur in the next period. The first order conditions with respect to Pj,t yields the
well-known optimal price setting equation as follows:
 N N
N
P∞ s N N Pt+s
P̃t  Ets=0 (βφN ) Ξt+s Yt+s mct+s PtN
= N N −1
(32)
PtN  − 1 P∞  Pt+s
s N mcN
Et s=0 (βφN ) Ξt+s Yt+s t+s PN t
N
P˜t N N
Note that if prices are completely flexible (i.e., φN =0), equation (32) simplifies to PtN
= N −1 mct . We
N
work with the condition of symmetric prices where P̃t = PtN , implying marginal cost would be equivalent
N −1
to the inverse mark-up, i.e. mcN t = N . It is convenient to express (32) recursively, which simplifies to
N N
N × f1,t = (N − 1)f2,t where:
 N N +1
N s Pt+1
f1,t = Ξt YtN mcN t + (βφN ) E t
N
f1,t+1 (33)
PtN
 N N
N s Pt+1
f2,t = Ξt YtN + (βφN ) Et N
f2,t+1 (34)
PtN
Prices can be expressed as a weighted average of the fraction of evolving in sector N firms which optimized
its price and those that did not optimize prices (which are stuck at charging prices from the previous period):
h
1−N
1−N i 1−1 N
PtN = (1 − φN ) PtN + φN Pt−1N
(35)

3.3 Monetary Policy

Consistent with recent empirical evidence from the Central Bank of Chile (e.g., Medina and Soto (2005),
Medina and Soto (2007), Kirchner and Tranamil (2016), Garcıa-Cicco et al. (2015) and Garcı́a-Schmidt and
Garcı́a-Cicco (2020)), the central bank conducts monetary policy by following a Taylor rule (Taylor, 1993)
via changing short-term interest rates in response to changes in the aggregate price level and output:

1 + rt

1 + rt−1
ρ h iω  Y ν 1−ρ
M α F 1−α t



= πt πt exp (εM P,t ) (36)
1+r 1+r Yt−1
which incorporates interest rate smoothing depending on the degree of inertia 0 < ρ < 1. The policy weights
with respect to deviations from the inflation rule and output are denoted ω and ν, respectively. The inflation
rule (36) makes an assignment on non-food (πtM ) and food sector (πtF ) inflation which is governed by 0< α ≤
1. This alternative Taylor rule allows a simple framework to evaluate whether the central bank pursues core
inflation (α = 1) versus a policy response that responds to food inflation (α < 1).10 εM P,t relates to a
monetary disturbance.
10 The assignment α is motivated by Anand et al. (2015) and subsequently Ginn and Pourroy (2019) who develop a DSGE
model to describe optimal inflation used in a welfare analysis.

9
3.4 Aggregation
Aggregate consumption (Ct ) and labor effort (Nt ) are defined, respectively:

Ct = (1 − λ) Ctn + λCtr (37)

M F
Nt = (1 − λ) Nr,t + λNn,t (38)
GDP is the sum of domestic consumption and exports.

Pt Yt = PtF CtF + PtM CtM + T BtF (39)

The balance of payment is equivalent to the trade balance (T Bt ) and the foreign asset position including
the net interest provision.

?
= St 1 + i?t−1 Br,t−1

?
St Br,t + T Bt (40)
FT FT FT MT
YtM T − CtM T



T Bt = Pt Yt − Ct + Pt (41)
?
Equation (40) represents the position on foreign bond holdings (Br,t ). Equation (41) shows that the trade
balance depends on the variation of the domestic value of tradable sector T sold abroad based on domestic
absorption.

4 Estimation Method
The model is estimated via Bayesian methods, which are commonly used in empirical macroeconomic re-
search (e.g., Schorfheide (2000), Smets and Wouters (2007), Fernandez-Villaverde and Rubio-Ramirez (2004)).
Bayesian DSGE models have also been used in business cycle research to understand commodity price shocks
(e.g. Medina and Soto (2005), Bodenstein et al. (2011), An and Kang (2011), Poghosyan and Beidas-Strom
(2011)).

4.1 Data
The model is based on eight observable variables (see Table 1). The sample period covers 1999:Q1 to 2018:Q1
which coincides with Chile’s fully-fledged inflation targeting framework.11

Table 1: Variable Selection

Description Source Mnemonic / Descriptor

Real GDP FRED NAEXKP01CLQ652S
Aggregate CPI FRED CHLCPIALLQINMEI
Food CPI FRED CHLCPIFODQINMEI
Core CPI FRED CHLCPICORMINMEI
REER FRED RBCLBIS
MPR Central Bank of Chile Policy Rate
International Food CPI World Bank Food CPI via “Pink Sheet”
Foreign interest rate U.S. Federal Reserve Shadow Federal Funds Rate

For consistency, CPI, food CPI, core CPI (defined as CPI less food and energy Price), international food
CPI and REER are seasonally adjusted using the U.S. Census Bureau’s ARIMA X12 algorithm. As the
international food price is quoted in nominal U.S. Dollars, we convert to the real value by dividing the former
by the U.S. CPI. The MPR and foreign interest rate12 are transformed from an annualized rate to a quarterly
Rtdata
gross interest rate to conform the model with observable data: Rtobs = 1 + 100×4 .
11 Chile abandoned its exchange rate band September 1999 in favor of a free-floating exchange rate policy, which paved the

way for a fully-fledged inflation targeting policy as a single nominal anchor (Morandé, 2002). The start period is consistent with
Del Negro and Schorfheide (2009), who estimate a Bayesian DSGE using data starting from 1999:Q1 considering the Central
Bank of Chile did not react significantly to exchange rate movements.
12 Considering the sample period overlaps with the U.S. federal funds rate was at the zero lower bound between 2008:Q4 until

2015:Q4, we use the shadow federal funds rate (Wu and Xia, 2016) to reflect the stance of U.S. monetary policy.

10
4.2 Calibrated Parameters:
The subjective discount factor (β) is set to 0.99. Labor attributed to the food sector (λF ) is set to 15%.13
The share of non-Ricardian household is set to 0.3795.14 While there is no sector specific indication on the
share of Ricardian and non-Ricardian household type, the model is based on the assumption that one-third
of the food sector is non-Ricardian, while two-third of the non-food sector is Ricardian. Lastly, the share of
food in total consumption (ϕF ) is set to 0.15.15

Table 2: Calibrated Parameters

Description Symbol Value

Population Labor Type
Non-Food Sector λM 0.85
Food Sector Ricardian Share λF r 0.33
Non-Food Sector Ricardian Share λM r 0.66
Utility
Discount factor β 0.99
Share of food in consumption ϕF 0.15

4.3 Prior Distributions:

The prior distributions of the estimated parameters are summarized in Table 3.
The prior specification builds mainly on recent empirical research from the Central Bank of Chile. Medina
and Soto (2005) estimate a SOE Bayesian DSGE model for Chile which explicitly models oil in both production
and consumption, where oil is interlinked with the international oil price subject to a law of one oil price
gap. Medina and Soto (2007) estimate a Bayesian DSGE which includes fiscal policy and a commodity sector.
Kirchner and Tranamil (2016) incorporate search and matching frictions in the labor market. Garcıa-Cicco
et al. (2015) estimate a model that incorporates financial frictions.
The prior on habit formation (Ricardian household) is set to 0.65 (e.g., Medina and Soto (2007) and
Garcıa-Cicco et al. (2015) use a prior set to 0.5 and 0.7, respectively). The labor inverse Frisch parameter χ
is set to unity (Medina and Soto (2005) and Garcıa-Cicco et al. (2015)).
The elasticity of substitution between tradable and non-tradable goods in the non-food sector (θM ) is set
to 1.5 (Kirchner and Tranamil (2016)). We assume the elasticity for tradable and non-tradable food (θF ) is
1.2. We set the elasticity of food (θ) to 0.65.16
As this is the first research investigating the coefficient estimate that controls for the weight on food and
non-food inflation (α) in the central bank reaction function, we use a diffuse prior by assuming the central
bank targets headline inflation, i.e. α has a prior equal to 1-ϕF .17 The prior for the interest rate smoothing
parameter is set to 0.7. The priors for the policy weights with respect to deviations from the inflation rule (ω)
and output (ν) are set to 1.5 and 0.5, respectively (Garcıa-Cicco et al. (2015) and Medina and Soto (2007)).
The Calvo price signal (φM ) in the non-food sector is assumed to be 0.75 (e.g., Medina and Soto (2007),
Kirchner and Tranamil (2016) and Garcıa-Cicco et al. (2015)). A low level of price stickiness is incorporated
in the non-tradable food sector, φM = 0.1.18
This paper draws on Schmitt-Grohé and Uribe (2003) by incorporating a bond adjustment cost; the prior
is set to ζ = 0.01.
13 According to World Bank data, agriculture represents 14% of employment in Chile for 1999 and 2000.
14 According to the World Bank Financial Inclusion Database, the share of access to financial institutions was 63% (age 15+)
for Chile in 2014.
15 The USDA Economic Research Service estimates that food represents 15.3% of total household expenditures for Chile in

2015.
16 The USDA (International Food Patterns) estimates the elasticity of food to be 0.679 for Chile.
17 Our argument is twofold: Chile targets headline inflation (Hammond, 2012) and recent research argues that targeting

strictly core inflation is not necessarily optimal (Anand et al. (2015), Catão and Chang (2015), Pourroy et al. (2016) and Ginn
and Pourroy (2019)).
18 We draw on the research of Gouvea (2007), who finds that processed food and non-processed food for Brazil display a low

degree of price stickiness.

11
 Table 3: Prior and Posterior Distributions

Prior Posterior
Density Mean StD Mean 90% interval StD
h Habit (Ricardian) B 0.65 0.1 0.6051 0.4411 0.7643 0.1107
χ Inverse Frisch G 1 0.2 1.3025 1.0079 1.6030 0.2106
ζ Bond Adjustment Cost IG 0.01 2 0.0116 0.0025 0.0231 0.0028
θ Elasticity of Substitution F and M G 0.65 0.2 0.6551 0.3366 0.9404 0.1899
θF F Elasticity of Substitution T and N G 1.2 0.2 1.1425 0.8759 1.4554 0.1947
θM M Elasticity of Substitution T and N G 1.5 0.2 1.5364 1.1756 1.8635 0.1995
φF N Calvo signal B 0.1 0.025 0.1256 0.0734 0.1716 0.0283
φF M Calvo signal B 0.75 0.05 0.8006 0.7461 0.8538 0.0396
α Policy Response (π) B 0.85 0.1 0.8114 0.7177 0.8961 0.0507
ρ Interest Rate Smoothing B 0.7 0.1 0.7110 0.6700 0.7648 0.0357
ω Taylor Rule Response Inflation G 1.5 0.1 1.6690 1.4853 1.8327 0.1003
ν Taylor Rule Response Output G 0.5 0.051 0.4207 0.3643 0.4919 0.0425
ρF T AR on FT Productivity B 0.5 0.1 0.6998 0.5929 0.8257 0.0705
ρM T AR on MT Productivity B 0.85 0.1 0.9326 0.8861 0.9862 0.0336
ρM N AR on MN Productivity B 0.85 0.1 0.8120 0.6160 0.9839 0.0846
ρF N AR on FN Productivity B 0.5 0.1 0.9281 0.9041 0.9529 0.0175
ρF ? AR on Foreign F Price B 0.75 0.1 0.8814 0.8476 0.9180 0.0221
ρM ? AR on Foreign M Price B 0.75 0.1 0.9802 0.9665 0.9918 0.0082
ρM P AR on Monetary Policy B 0.75 0.05 0.5602 0.4988 0.6319 0.0448
ρi? AR on Foreign Interest Rate B 0.46 0.05 0.7237 0.6856 0.7596 0.034
ρΨF AR on Food Law One Price B 0.75 0.1 0.7989 0.6769 0.9132 0.0782
ρΨM AR on Manufacturing Law One Price B 0.75 0.1 0.7798 0.6663 0.9061 0.0865
σM N StD MN Productivity IG 0.02 2 0.0069 0.0044 0.0090 0.0013
σM T StD MT Productivity IG 0.02 2 0.0179 0.0138 0.0221 0.0025
σF T StD FT Productivity IG 0.02 2 0.0518 0.0371 0.0670 0.0090
σF N StD FN Productivity IG 0.02 2 0.0781 0.0675 0.0899 0.0079
σM P StD on Monetary Policy IG 0.02 2 0.0034 0.0029 0.0038 0.0004
σM ? StD. on Foreign M Price IG 0.02 2 0.0337 0.0288 0.0381 0.0031
σF ? StD on Foreign F Price IG 0.02 2 0.0612 0.0532 0.0700 0.0049
σM P StD on Foreign Interest Rate IG 0.02 2 0.0033 0.0027 0.0039 0.0003
σ ΨF StD on Food Law One Price IG 0.02 2 0.0088 0.0052 0.0118 0.0022
σ ΨM StD on Manufacturing Law One Price IG 0.02 2 0.0099 0.0055 0.0144 0.0024
Note: distributions include Beta (B), Gamma (G) and Inverse Gamma (IG). “StD” for standard deviation, “F” food,
“M” non-food, “FT” food tradable, “FN” food non-tradable, “MT” non-food tradable, “MN” non-food non-tradable.

4.4 Empirical Findings

4.4.1 Posterior Distributions
Table 3 reports the prior and posterior distribution using a Metropolis Hasting algorithm.
The estimated habit formation (h) is 0.61.19 The inverse Frisch is estimated at χ = 1.30. Food has an
inelastic demand; θ is estimated to be 0.66. The elasticity of substitution between tradable and non-tradable
goods in the food (non-food) sector is lower (higher) than the prior: θF = 1.14 (θM = 1.54).
The posterior Calvo probabilities for the manufacturing (φM ) and food sectors (φF ) is estimated to be
0.13 and 0.80, respectively.20 Therefore, we conclude that food prices are quasi -flexible which lends support
with the empirical literature (Gouvea, 2007).
The interest rate smoothing parameter ρ has a posterior mean of 0.71 suggesting the presence of policy
inertia.21 The policy coefficients for the inflation (ω) and the output gap (ν) are estimated to be 1.67 and
0.42, respectively.22
The posterior for α is less than unity (0.8114), providing empirical support that the Central Bank of Chile
19 This is consistent with Medina and Soto (2007) and Garcıa-Cicco et al. (2015), who estimate a posterior of 0.65 and 0.74,
respectively.
20 The posterior Calvo probability estimate (φ ) is similar with the posterior estimates found in Medina and Soto (2007) who
M
find a posterior value of 0.74
21 The posterior result is in line with Medina and Soto (2007), Garcıa-Cicco et al. (2015) and Garcı́a-Schmidt and Garcı́a-Cicco

(2020) who find a posterior of 0.74, 0.83 and 0.77, respectively.

22 The posterior result for ω (ν) is in line with Medina and Soto (2007) and Garcıa-Cicco et al. (2015) who find a posterior of

1.67 (0.39) and 1.54 (0.12), respectively.

12
pursues inflation targeting with a focus on both core inflation and food inflation over the sample period.23 We
compare the fit of three models based on the degree of α, where monetary policy targets core inflation (M1 for
α = 1); headline inflation (M2 for α = 0.85); and an empirical-based inflation (M3 for α = 0.8114) target.
The criteria is based on the log marginal data densities and the corresponding Bayes factor summarized
in Table 4. Based on the Bayes factor derived from the empirical estimation suggests the empirical-based
inflation target rule (M3 ) is more favored by the data.24

Table 4: Model Comparison

Model Inflation Target Model ln p(Y |Mi ) Bayes Factor vs. M1
M1 Core (α = 1) 1452.23 1
M2 Headline (α = 0.85) 1469.17 exp(16.94)
M3 Empirical (α = 0.8114) 1478.27 exp(26.04)
Note: M3 is the empirical model used in this paper. The log data
density for the three models is computed using the modified harmonic
mean (Geweke, 1999).

Overall, the empirical evidence suggests that the Central Bank of Chile does indeed respond to food price
deviations in the short run. This result is consistent with the Central Bank of Chile’s policy target measure
using headline prices.25
We investigate monetary policy responses over two periods, summarized in Table 5. The first period covers
1999:Q1 to 2007:Q1 and the second period covers 2007:2 until 2018:1.26 The latter may be characterized as
more volatile than the former period, largely attributed to food prices shocks.27 The posterior results suggests
the interest rate smoothing (ρ) has increased in the second period, while the policy reaction to inflation (ω)
has marginally decreased. The reaction to core inflation has been less pronounced (due to a decrease in α) in
the second period. Table 5 demonstrates the posterior estimate for the reaction to core inflation (α) in the
second period is outside the 90% confidence interval of the first period.28

Table 5: Monetary Policy: Posterior Parameters

1999:Q1-2007:Q1 2007:Q2-2018:Q1 1999:Q1-2018:Q1
0.8956 0.7995 0.8114
Reaction to core inflation α
[0.8096,0.9870] [0.6933,0.8985] [0.7177,0.8961]
1.6064 1.5879 1.6690
Reaction to inflation ω
[1.4657,1.7374] [1.4237,1.7361] [1.4853,1.8327]
0.4635 0.4617 0.4207
Reaction to output gap ν
[0.3863,0.5274] [0.3919,0.5449] [0.3643,0.4919]
0.5421 0.6858 0.7110
Interest rate smoothing ρ
[0.4351,0.6588] [0.6102,0.7624] [0.6705,0.7650]
Note: for each variable the parameter estimate is provided in the first row, whereas the 90% confi-
dence set is provided in the second row.

4.4.2 Second Moments and Variance Decomposition

We report the second moments in terms of the standard deviation and autocorrelation from the data relative
to the empirical model (corresponding with the estimated model, i.e. a simulation with all parameters equal
23 This is consistent with a recent study by Garcı́a-Schmidt and Garcı́a-Cicco (2020).
24 The Bayes factor is an empirical test to quantify the support of one model relative to an alternative model. According to
Kass and Raftery (1995), values between 1-3 implies “not worth more than a bare mention”, between 3-20 “positive” evidence,
between 20-150 “strong” evidence and greater than 150 “very strong” evidence.
25 According to Central Bank of Chile (2007), “Chile’s Central Bank uses the CPI as the base index for defining inflation

targeting: its advantages in terms of representative and credibility prevail over the disadvantages of volatility” (p. 16).
26 We partition the sample period based on a structural break test detected at 2007:2 (based on the logarithm food price),

which corresponds with the increase in aggregate inflation depicted in Figure 4.

27 The standard deviation for aggregate (food) inflation of the first and second period is 0.0041 (0.0089) and 0.0080 (0.0154),

respectively.
28 The posterior estimate for α (0.7995) in the second period is outside the 90% confidence interval of the first period (i.e.,

[0.8096, 0.9870]).

13
to the estimated posterior means). The model tends to overpredict the volatility of output, inflation and the
interest rate (Table 6). The persistence between the data and estimated model for output, inflation rate and
interest rate are similar at order 1. The model struggles to capture the first order autocorrelation for the
exchange rate (Table 6), noting the persistence of the exchange rate tends to converge in the short-term (i.e.,
at order 2) as Figure 5 demonstrates.

Table 6: Business Cycle Statistics

Output Inflation Interest rate Exchange rate
Standard Deviation
Data 0.0076 0.0069 0.0043 0.0353
Model 0.0288 0.0098 0.0098 0.0347
Autocorrelation (order=1)
Data 0.967 0.557 0.852 0.089
Model 0.889 0.372 0.787 -0.019
Note: “Data” refers to actual values; “Model” refers to the DSGE
model estimated values.

Figure 5: Autocorrelation

We report the conditional variance decomposition in Table 7 at different time horizons (quarters 1, 4
and 8). The non-food technology shocks account for the majority of output fluctuations. In the short-
term (quarter 1), the international food (manufacturing) price accounts for around 9% (0%) and 3% (1%) of
domestic inflation and the policy rate, with a long-run (quarter 8) effect of 9% (0%) and 2% (1%), respectively.
The international food price and the deviations from the law of one price (food and manufacturing) exhibit
large contributions in explaining variability in inflation, the exchange rate and the policy rate.

5 Effects of a World Food Price Shock

The posterior impulse response functions (IRF) are presented in Figures 6, 7 and 9 with a 90% coverage band.
The IRFs display a one standard deviation shock to the global food prices.

5.1 Effect on Inflation

Considering that food represents a non-trivial share of expenditures, that domestic food prices are quasi-
flexible and that food has an inelastic demand, an increase in global food prices translates to higher domestic
food inflation.29 In addition, non-food inflation also increases, albeit with a lethargic delay of around two
periods. As shown on Figure 6, headline inflation increases simultaneously with the world food price shock (at
29 The world food price shock translates into a term of trade shock in the domestic economy. As the tradable sector is

assumed to be perfectly competitive, a higher food price results in higher labor demand. This generates a new equilibrium in
the labor market resulting in a higher wage. As labor is mobile between tradable and non-tradable food sector, the wage (and

14
 Table 7: Conditional Variance Decomposition
Productivity World World Monetary World Food Manuf.
FT MT MN FN PF? P M? Policy i? LOP LOP
Quarter 1
Growth (∆lnYt ) 0.02 1.55 43.05 7.23 26.84 8.23 4.60 2.03 2.77 3.68
Inflation (πt ) 15.07 0.20 7.91 11.87 9.28 0.03 9.73 37.37 5.12 3.42
Exch. rate (∆et ) 12.48 60.82 8.54 2.92 5.14 0.40 0.34 0.84 4.91 3.62
Interst rate (Rt ) 32.87 1.18 5.33 28.18 2.92 1.35 14.86 0.50 7.99 4.82
Quarter 4
Growth (∆lnYt ) 0.05 1.51 41.48 7.84 25.82 8.38 5.16 2.79 2.97 4.01
Inflation (πt ) 13.46 0.57 7.43 10.73 8.87 0.33 8.85 41.19 5.05 3.52
Exch. rate (∆et ) 13.07 59.22 8.65 3.45 5.02 0.40 0.40 0.92 5.11 3.76
Interst rate (Rt ) 31.91 0.71 9.10 23.75 1.51 0.76 14.57 1.88 9.52 6.30
Quarter 8
Growth (∆lnYt ) 0.05 1.51 41.30 7.89 25.80 8.44 5.19 2.76 3.01 4.05
Inflation (πt ) 13.54 0.73 7.44 10.57 8.90 0.34 8.72 41.23 5.03 3.50
Exch. rate (∆et ) 13.17 58.86 8.68 3.46 5.03 0.42 0.40 0.93 5.20 3.84
Interst rate (Rt ) 31.66 1.15 10.19 21.61 1.60 1.16 14.05 1.85 9.99 6.75
Note: The columns indicate the respective shock. Each shock is treated as an AR(1) process. “FT” refers to
food tradable, “FN” food non-tradable, “MT” non-food tradable, “MN” non-food non-tradable, “P F ? ” the world
food price, “P M ? ” the world non-food price, “i? ” the world interest rate, food law of one price (LOP) gap and
manufacturing (”Manuf.”) LOP gap.

time 0) while core inflation displays its highest value after two quarters. This is interpreted as a second-round
feature that a food price shock has on non-food prices. This provides evidence consistent with theory: food
prices can propagate inflation through its effects on inflation expectations (Walsh, 2011).

Figure 6: IRF World Food Price Shock on Inflation

0.12 0.035 0.025

0.03
0.1
0.02
0.025
0.08
0.02
0.015

0.06 0.015

0.01
0.01
0.04
0.005
0.005
0.02
0

0 -0.005 0
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10

World Food Price Headline Inflation π Core Inflation π M

5.2 Effect on Policy Rate

Considering the inflationary pressure from the food price shock, the IRF suggests the central bank raises the
policy rate by around twenty basis points.30 As expected, policy tightening leads to lower demand and an
appreciation of the domestic currency (see Figure 7).
To get a deeper understanding of what drives the interest rate response, we decompose the interest rate
IRF according to the elements that make up the Taylor rule (see Figure 8). At the time of the world food
price shock (period 1), the central bank responds via increasing the interest rate. This reaction is due to the
observed posterior on α and is only driven by food inflation. Non-food inflation plays a role only in subsequent
hence marginal cost) in the non-tradable food sector increases too. Thus, non-tradable food price increases following the rise in
workers’ nominal wage, but to a lesser extent due to nominal rigidities. Consequently, the price of purely domestic food variety
increases as well. This is the pass-through from world market to domestic consumer. Due to nominal rigidities in non-tradable
food sector, high prices remain after the world food price shock. In the non-food sector, the exchange rate appreciation impacts
negatively the price of tradable non-food good. During the following periods, the interest rate, demand, wages and prices increase
back to the pre-shock levels.
30 Twenty basis points means a 5.10e-3 deviation from a 4% steady state rate.

15
 Figure 7: IRF World Food Price Shock
-3 -3
10 10 10-3
7 1 0 9

0.5 8
6 -0.002
7
0
5 -0.004 6
-0.5
5
4 -1 -0.006
4
3 -1.5 -0.008
3
-2
2 -0.01 2
-2.5
1
1 -0.012
-3 0

0 -3.5 -0.014 -1
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10 2 4 6 8 10

Interest rate Consumption Exchange Rate Trade Balance

periods when second-round effects begin to take hold. The output gap plays little role in explaining the policy
response.
Immediately after the shock, the interest rate response is positive, albeit starts to taper off. Domestic
food prices are quasi-flexible and headline inflation quickly falls. If we put aside the effect of smoothing, the
interest rate response slowly dissipates to curtail the propagation effect that food prices have on non-food
inflation.
We find the output-gap deviation from steady-state is not large enough to impact central bank reaction to
the food price shock. In the non-food sector, the food price shock and following central bank reaction leads to
a shift from tradable to non-tradable goods production. The output gap remains small and does not appear
to be a key interest rate driver.
Monetary policy drivers
Figure 8: Policy Rate Decomposition Following a World Food Price Shock
X10‐3
5
Reaction to Food Inflation
Reaction to Non-food Inflation
4
Reaction to Output-gap
Smoothing
IRF

3
Interest Rate

-1
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Time

We therefore conclude that while a shock on food prices does not imply a high volatility of activity,
second-round effects on core inflation lead to a long-lasting increased response in interest rates.

5.3 Effect on Output and Labor

Considering that food has a non-trivial role in the consumption basket, a food price shock can potentially
aggravate domestic output through its effects on demand. An increase in the world food price leads to a
lower domestic consumption for tradable and non-tradable food. The overall demand for non-food goods also
decreases, however the non-tradable sector slightly increases. Tradable non-food goods decrease considering
the currency appreciation (i.e., non-tradable non-food goods are relatively more expensive). Overall, the IRF
suggests a global food price increases the trade balance driven by higher food exports, which is slightly offset
by lower non-food exports (see Figure 9). While aggregate consumption decreases, there are compositional
effects by sector and household type. The non-Ricardian household type working in the food sector has a
positive wealth effect relating to higher real wages. A rise in food prices puts upward pressure on food sector

16
wages and non-Ricardian consumption in the food sector increases somewhat monotonically in the absence
of this household type able to smooth consumption. In contrast to the non-Ricardian food household, the
Ricardian food household observes a transitory, hump shaped decrease in consumption (partially driven by
habit formation), due to a higher policy rate.
While labor for both food household types rises, Ricardians increase labor more intensely than non-
Ricardians to benefit from higher wages. Non-food households face a lower real income as the overall demand
for non-food goods slightly decreases; their wages decrease. Labor effort is also reduced for non-food house-
holds.

6 Welfare
Considering the increased food price volatility since the turn of the century, we find it natural to assess the
existing research by confronting theory with data. We assess the implications of monetary policy choice of
an inflation target via second-order welfare approximation. We consider the welfare gains (in consumption
units) based on a policy response that stabilizes core inflation (α=1), the empirical model (α=0.8114) and
headline inflation (α=0.85). All models have the same steady state. Following Faia and Monacelli (2007), we
define welfare by household type as follows:
(∞ )
X
n

Wi,t = Et β Ui (Ci,t+n , Ni,t+n )  (42)
n=0 x0 =x

Following Schmitt-Grohé and Uribe (2004), Adjemian et al. (2011) and Pourroy et al. (2016) the second-order
welfare approximation takes the following form :
1 1
W = E−1 {W0 }|y−1 =ȳ = W̄ + [gσσ ] + {[guu (u1 ⊗ u1 )]} ,
2 20
where W̄ denotes the welfare value at the steady-state, gσσ the second derivative of the policy function (g)
with respect to the variance in the shocks, and guu the Hessian of g with respect to shock vector u. Welfare
is defined as the respective share of each household (Pourroy et al., 2016):

Wt = (1 − λ)Wr,t + λWn,t
We present the results of the welfare evaluation in Table 8 relative to aggregate welfare based on headline
inflation targeting.31 Welfare gains are defined as additional consumption needed to make the level of welfare
under headline inflation targeting identical to that under the evaluated policy. Thus, a positive (negative)
number indicates that welfare is higher (lower) relative to headline inflation targeting. We estimate welfare
using a second order approximation assuming all parameters are at the posterior mean.
Our findings suggest that welfare is improving as monetary policy is oriented towards headline inflation
followed marginally by the empirical model. The Chilean monetary policy via the empirical model and core
inflation targeting is estimated to deliver a welfare of -0.04% and -2.73% lower than it would with headline
inflation targeting, respectively. We further decompose welfare by food and non-food sectors by household
type. Our findings suggest that monetary policy that stabilizes headline inflation is at least welfare improving
for all agents decomposed by sector. While core prices may be conjectured to be a suitable target measure,
recent history has shown food price changes have not necessarily been mean-reverting, where core inflation
has been partially propagated by food inflation.

31 Headlineinflation targeting is taken as a basis to compare alternative welfare policy rules considering that Chile targets
headline inflation (Hammond, 2012).

17
 Table 8: Welfare Comparison (%)
Aggregate Non-Food Sector Food Sector
NF
W Wr Wn W WrN F WnN F W F
WrF WnF
Headline Inflation 0.00 -0.06 0.08 0.13 0.07 0.24 -0.73 -1.41 -0.38
Empirical Model -0.04 -0.09 0.05 0.09 0.03 0.21 -0.73 -1.41 -0.38
Core Inflation -2.73 -3.18 -1.99 -2.89 -3.13 -2.40 -1.84 -3.77 -0.85
Note: all models are based on the posterior mean. Empirical Model corresponds with the estimated model.
Welfare is presented relative to aggregate welfare based on headline inflation targeting.

7 Conclusion
In this paper, we discuss how the business cycle of a net-food exporting country in a small open economy
setting is affected by food price volatility. The model is applied using Chilean data.
A number of interesting results emerge. Firstly, this is, to our knowledge, the first paper which incorporates
food into production and consumption in a Bayesian DSGE framework. While monetary policy was strongly
oriented on core inflation, food inflation played a non-trivial role in shaping monetary policy actions in
stabilizing inflation, more so during the recent period (characterized by higher food price volatility) relating
to 2017:Q2-2018:Q1 relative to 1999:Q1-2007:Q1. This empirical link implies a revealed preference of the
actions of the Central Bank of Chile in response to developments in both core and headline price indices,
consistent with its policy goal.
Secondly, the IRFs from a global food price shock suggest there are second-round effects. This conclusion
is drawn from an increase in core inflation after a food price shock. It is natural core inflation may be
subject to a spillover effect from food inflation. These results do not necessarily coincide with the current
consensus of an optimal policy based on core inflation targeting. In the presence of a second-round mechanism,
the Chilean experience demonstrates the classical view of targeting core inflation to be optimal may be too
narrow, whereby optimal policy would require an immediate response since the policy rate has a lagged effect.
Interestingly, we show that core inflation may increase even if the Central Bank of Chile tightens its monetary
policy in response to a rise in food inflation. Even though the Central Bank of Chile were to target headline
inflation, the effect of food price volatility was found to persist on core inflation despite the policy response
to curtail its effect.
While the theoretical literature tends to side with core inflation as an optimal policy target (e.g. Good-
friend (2007)), all central banks that have adopted inflation targeting actually target headline inflation (see
Hammond (2012)). Based on a second-order welfare analysis using the posterior values, we find that targeting
headline inflation provides a higher welfare gain than core inflation. Therefore, our paper contributes to close
a gap between theory and practice. This underscores the importance of a central bank to craft an appropriate
policy response that monitors and addresses sectoral price developments. Overlooking the effects that a food
price shock has on future inflation could potentially move inflation away from central bank’s target, thereby
weakening central bank’s monetary anchoring.

18
 Figure 9: IRF World Food Price Shock: Output and Labor
10-3
0.1 0.02 0.014 2

0.09
0.012
0.015 0
0.08

0.07 0.01
0.01 -2
0.06
0.008
0.05 0.005 -4
0.006
0.04
0 -6
0.03 0.004
0.02
-0.005 -8
0.002
0.01

0 -0.01 0 -10
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10 2 4 6 8 10

F M
W W Export Food Export Non-Food

10-3 10-3 10-3 10-3

9 0 2 4.5

8 -0.5 4
1
3.5
7 -1
0
3
6 -1.5
-1
2.5
5 -2
-2 2
4 -2.5
1.5
-3
3 -3
1
-4
2 -3.5
0.5

1 -4 -5
0

0 -4.5 -6 -0.5
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10 2 4 6 8 10

FT FN MT MN
Y Y Y Y

10-3 10-3
1 0 1 0.08

0 0
-0.002 0.07
-1 -1
0.06
-2 -0.004 -2
0.05
-3 -3
-0.006
-4 -4 0.04
-0.008
-5 -5
0.03
-6 -0.01 -6
0.02
-7 -7
-0.012 0.01
-8 -8

-9 -0.014 -9 0
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10 2 4 6 8 10

M Ric Cons. M Non-Ric Cons. F Ric Cons. F Non-Ric Cons.

10-3 10-3 10-3

4 1 0.08 6

3
0.07 5
0.5
2
0.06
1 4
0
0.05
0
3
-1 -0.5 0.04
2
-2
0.03
-1
-3 1
0.02
-4
-1.5
0.01 0
-5

-6 -2 0 -1
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10 2 4 6 8 10

M Ric Labor M Non-Ric Labor F Ric Labor F Non-Ric Labor

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