Got Milk? The Effect of Export Price Shocks on Exchange Rates
Terms of trade increases should, in theory, cause nominal exchange rate appreciations through the consumer price index (CPI) and price stickiness. However, the actual effect has remained difficult to identify and quantify empirically. This effect is of interest especially to economies that rely on the export of a single commodity; however, many of those economies may struggle to identify the casual link between exchange rates and commodity prices if they focus on potentially confounding internal factors. For example, because these countries often export a significant portion of a commodity’s world supply, domestic supply may affect the price of the commodity, and domestic CPI may affect exchange rates. This paper focuses on the dairy auctions of New Zealand, specifically the auctions of whole milk powder. The auctions provide an opportunity to find and measure shocks to external demand for the commodity, which are exogenous to the domestic economy. Similar to other settings with a primary commodity export, the auctions involve a single product that accounts for a large portion of the export price index. Therefore, when dairy prices rise in New Zealand dollar terms, the increase should have a detectable effect on the export price index and the exchange rate.
- A 1 percent increase in the auction price of whole milk powder has a modest but significant effect on New Zealand’s nominal exchange rates that does not seem to be explained by interest rate movements.
- The effect seems to be driven by a combination of a financial flows channel and a fundamental channel. Under the financial flows channel, exchange rates move with export prices because an increased export flow increases the global demand for the New Zealand dollar. Under the fundamental channel, an increase in the price of whole milk powder from an external demand shock causes an increase in prices across production sectors in the domestic economy. In response to these higher prices, real exchange rates appreciate, and under sticky prices, nominal exchange rates appreciate as well.
This paper’s finding that export price increases do indeed cause exchange rate appreciations (and vice versa) is particularly applicable to countries whose exports comprise only a small number of commodities. The finding is especially relevant to policymakers in those countries, because they should understand the extent to which commodity prices will affect their exchange rates.
I examine the effect of exogenous terms of trade shocks on an exchange rate by turning to New Zealand’s dairy auctions. Dairy is New Zealand’s largest export category, making up almost 20 percent of exports. Specifically, whole milk powder accounts for 6 to 11 percent of total exports, and its price is determined in twice-monthly auctions. I use event studies to quantify the impact of surprise auction results on the New Zealand dollar on a high-frequency basis. I find that a 1 percent increase in whole milk powder prices has a modest, but nevertheless significant, effect on the nominal exchange rate that does not seem to be explained by interest rate movements. Rather, the effect seems to be driven by a combination of two channels: a financial flows channel and a fundamental channel. The methodology developed here can potentially be applied to other commodity exporters.