(1980) argue that price shocks stemming in oligopolistic non-agricultural sector and
accommodated by expansionary monetary policy, cause inflation and place agriculture in a
price-cost squeeze.
Other streams of research address the broader macroeconomic environment. Arising from
Dornbusch’s (1976) overshooting models of exchange rate determination, these studies
establish the linkages among exchange rates, money, interest rate and commodity prices.
Frankel (1986) applied Dornbusch’s model in which exchanges rates, money supply, interest
rate and aggregate demand determine commodity prices assuming closed economy. He
emphasised the distinction between “fix-price” sectors (manufacturers and services sector),
where prices adjust slowly and “flex-price” sector (agriculture), where prices adjust
instantaneously in response to a change in the money supply. In Frankel’s model, a decrease
in nominal money supply is a decline in real money supply. This leads to an increase in
interest rate, which in turn depresses real commodity prices. The latter then overshoot
(downward) their new equilibrium value in order to generate expectation of a future
appreciation sufficient to offset higher interest rate. In the long run, all real effects vanish. Lai,
Hu and Wang (1996) employed Frankel’s framework and phase diagram to investigate how
money shocks influence commodity prices. They found that with unanticipated monetary
shocks, commodity prices overshoot, but, if manufactured prices respond instantly,
commodity prices undershoot. Saghaian, Reed and Marchant (2002) extended Dornbusch’s
model with agricultural sector and allowing for international trade of agricultural
commodities. Agricultural prices and exchange rate are assumed flexible, while industrial
prices are assumed to be sticky. Employing small open country assumption, they showed that
when monetary shocks occur, the prices in flexible sectors (agriculture and services)
overshoot their long-run equilibrium values. Furthermore, they showed that with presence of a
sticky sector, in case of monetary shock, the burden of adjustment in the short run is shared
by two flexible sectors and having a flexible exchange regime decreases the overshooting of
agricultural prices and vice versa. The extent of overshooting in the two flexible sectors
depends on the relative weight of fix-price sector.
All studies found significant effects of changes in macroeconomic variables for monetary
policy and exchanges rates in the short run. Several authors found that farm prices respond
faster than non farm prices, which consistent with hypothesis that relative prices change as
money supply changes due to price level in the various sectors change differently (Bordo
1980, Chambers 1984, Orden 1986a and 1986b, Devadoss and Meyers 1987, Taylor and