Combating Commodity Price Volatility in Canada

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Table of Contents

Executive Summary
Introduction
Causes of Volatility in Canada
The Significance of Commodity Price Volatility in Canada
Rationale for Action
Strategy for Combating Commodity Price Volatility
Conclusion
References

Executive Summary

This paper analyzes the problem of commodity price volatility in Canada. It also discuses various policy proposals that can be adopted by the government of Canada to reduce price volatility. Commodity price volatility refers to the variations in the prices of various commodities over a given period of time. Such variations are least harmful if they are a true reflection of the market fundamentals.

However, large and persistent fluctuations in commodity prices have severe consequences on economic growth. They particularly result into a slow economic growth, high unemployment rate, reduced investment rates and low profits (Barro, 2008, p 123). The significance of commodity price volatility in Canada is based on the fact that the country is a major producer and exporter of primary commodities.

Thus fluctuations in the prices of such commodities have direct negative impacts on its economic performance. In Canada, the volatility is mainly driven by supply and demand shocks emanating from the international commodity market, rise in demand for commodities in emerging market economies and the actions of speculators (Murray, 2011).

The strategies recommended for combating the volatility include supply management, market-based mechanism, stabilization fund and diversification. The government should also strengthen social safety nets and enhance transparency and sharing of information concerning market conditions.

Introduction

Volatility simply means “variations in economic variables” (Barro, 2008, p 122). Thus commodity price volatility refers to the variations in the prices of various commodities over time in particular markets. Variations in prices are not problematic if they follow a smooth trend. This is because such variations are a reflection of market fundamentals.

However, large and unpredictable price variations are problematic since they create uncertainties in the market. The risks faced by producers, consumers and even the government increase as the level of uncertainty about the prices increases. Large price variations can also lead to incorrect or sub-optimal decisions (Mankiw, G. 2002, p. 104).

It is for this reason that policy authorities strive to ensure stable commodity prices in the economy. This paper focuses on commodity price volatility that is currently being experienced in Canada. Various policy recommendations on how the volatility can be addressed will be presented alongside their pros and cons.

Causes of Volatility in Canada

Since 2002, Canada has witnessed episodes of high commodity prices followed by sharp falls in the prices. Thus predicting the magnitude and timing of variations in commodity prices has been very difficult. Shifts in demand and supply for commodities at the global level are the main causes of price volatility in Canada (Murray, 2011). This is attributed to the fact that Canada is a major exporter of various commodities.

Thus supply and demand shocks in the international market have a direct effect on its domestic prices (Mankiw, G. 2002, p. 107). The increase in demand for commodities in emerging market economies (EMEs) has also made significant contributions to the upsurge in commodity prices. The EMEs have particularly contributed to the rise in prices of foodstuffs and household products.

Finally, the volatility in commodity prices has been caused by the actions of speculators. The speculators normally hold stocks of various commodities as they wait for the prices to increase. However, such acts lead to artificial shortages which result into large variations in prices (Mankiw, G. 2002, p. 110). Commodities whose prices have experienced severe fluctuations include copper, cattle and oil.

The Significance of Commodity Price Volatility in Canada

Unlike other developed countries, Canada is a major producer of primary commodities. It is the leading exporter of primary commodities among the G7 member countries (Murray, 2011). The commodity sector is very important in the country since it accounts for 11 percent of its GDP (Murray, 2011).

Thus the sector is a major source of revenue and employment in Canada. Besides, it promotes growth in other sectors of the economy such as manufacturing by supplying them with raw materials as well as creating demand for goods produced in other sectors. The resource sector for instance is a major source of income and also enhances induced investment.

The primary commodities are also important to the country since they account for one third of its exports. Volatility in commodity prices has thus had adverse effects on Canada’s economy. It has particularly worsened the country’s terms of trade and slowed the growth of its GDP (Murray, 2011). It has equally led to high levels of unemployment and poverty as production slumps while consumers’ purchasing power declines.

The benefits of high commodity prices such as high revenues received by producers are normally offset by the subsequent reduction in aggregate demand. Due to the negative effects of the price volatility on the performance of Canada’s economy and the decline in the quality of life, it is important to stabilize the prices.

Rationale for Action

Tackling the problem of commodity price volatility in Canada is important due to the following reasons. First, the profitability of firms involved in the production and sale of commodities will increase if variations in prices reflect market fundamentals (Krugman, 2009, p. 91). Stable and predictable incomes enhance induced investments.

Second, more job opportunities will be created as firms continue to invest thereby reducing the level of unemployment. Third, the quality of life will improve if consumers are able to realize smooth consumption patterns through stable commodity prices (Krugman, 2009, p. 94). Finally, stabilizing the commodity prices will stimulate economic activity. This will translate into high growth in gross domestic product.

Strategy for Combating Commodity Price Volatility

Volatility in commodity prices is normally caused by several factors which could be related or unrelated. Thus formulating a policy for combating volatility in commodity prices calls for an in-depth analysis of the causes of the volatility. A variety of policies should then be formulated and implemented to stabilize the prices. The government of Canada can thus consider the following measures as responses to the volatility.

Supply Management

One of the major causes of commodity price volatility is the fluctuations in the quantities of such commodities supplied in the market. When the supply exceeds demand, the prices tend to fall below the equilibrium level (Krugman, 2009, p. 78). Thus producers lose by receiving low prices. However, when supply is less then demand the prices tend to increase above the equilibrium level.

Stabilizing the prices towards the equilibrium level can be achieved by financing buffer stocks. This means that the government can provide financial incentives to enable the producers to hold emergency stocks of the various commodities. Besides, compensatory financing facilities such as insurance should be provided to compensate for the shortfall in producers’ incomes due to short term price shocks.

This strategy is justified by the fact that it facilitates consistent supply of commodities which leads to price stability especially in the short run. Its main strength is that both the government and the private sector can mobilize resources to implement it (Minh, 2011, pp. 956-965).

For example, the government can provide subsidies to producers to encourage holding of emergency stock while the private sector can provide the insurance services. The disadvantage of this strategy is that speculators might hold stocks for too long which leads to artificial shortages and high prices (Minh, 2011, pp. 956-965). Besides, increase in cost of production can lead to higher prices in the long-run.

Market-Based Mechanism

This involves the use of financial instruments such as price hedging. In this case, the buyers and sellers sign forward contracts. Such contracts specify in advance the price at which a particular commodity will be bought over a certain period of time (Pindyck, 2004, pp. 1029-1047). For example, most producers usually hedge the price of oil in order to shield themselves from the effects of oil price fluctuations.

The justification of this strategy is based on the fact that the buyer is able to benefit from predictable prices in the short run. The seller on the other hand will benefit from predictable and stable revenues in the short run (Pindyck, 2004, pp. 1029-1047). The challenge in using the market-based mechanism is mainly attributed to the complexity of the financial facilities.

Most government officials and even the traders are not familiar with facilities such as forward contracts and futures (Pindyck, 2004, pp. 1029-1047). Thus the government should focus on stakeholder education before implementing this strategy. Besides, internal control measures should be put in place to prevent speculative transactions.

Stabilization Fund

Volatility in commodity prices usually has a negative effect on government revenues. Thus fluctuations in budgetary revenue can be reduced by establishing a stabilization fund (Deepeshree and Agarwal, 2006, p. 76). Implementing the strategy involves channeling revenue to the fund during the boom periods. It is advisable to set a specific amount of money to be raised during the boom period.

Transfer is then made from the fund to finance the budget during recessions. The justification for this strategy is attributed to the fact that it helps in stabilizing the business cycle, thereby stabilizing prices (Deepeshree and Agarwal, 2006, p. 77).

The main advantage of this strategy is that it not only stabilizes the prices but also ensures stable and consistent economic growth over time. A stable business cycle promotes investment and employment in the economy. The strategy also results into an improvement in the quality of life (Varali, and Gabriel, 2009, pp. 67-72).

This is due to the fact that the money accumulated by the fund can be used to provide basic services such as health care and education during recessions.

The challenges associated with the strategy include the following. First, the rules governing the operation of the fund can be easily changed. Thus the fund can be used to finance inappropriate projects. Second, it is often difficult to predict revenue streams as well as the magnitude and duration of price shocks (Verma and Hertel, 2009, pp. 405-415). This makes it difficult to implement the appropriate counter cyclical policies.

In response to these weaknesses, the government should establish a legal framework that will prevent misappropriation of the fund. The government should also focus on monitoring macroeconomic variables in order to correctly predict its revenue streams and price fluctuations.

Diversification

Diversification involves reducing over dependence on primary commodities by encouraging growth in other sectors such as manufacturing (Moledina, Roe and Shane, 2008, pp. 798-812). Price fluctuations normally occur when the government tries to promote production of primary commodities in order to meet its revenue requirements.

Such initiatives can result into over production which leads to low prices especially when the international market is saturated. The producers and the government will thus have stable revenues through diversification. Diversification can be implemented in two forms which are as follows.

First, the government can adopt a horizontal diversification strategy by encouraging the production of alternative commodities whose prices seem to be stable in both domestic and international market (Moledina, Roe and Shane, 2008, pp. 798-812).

Second, it can focus on horizontal diversification by promoting the production of primary commodities as well as improving the value chain. In this case, value addition is enhanced in order to improve the competitiveness of the commodities.

Diversification is justified by the fact that it will enable the government of Canada to avoid a huge shortfall in its revenue when the prices of primary commodities fall. Besides, it will enable the government to develop other sectors of the economy which might be ignored as it concentrates on the production of primary commodities (Moledina, Roe and Shane, 2008, pp. 798-812).

Diversification is however, associated with two weaknesses. Its implementation can be slowed by structural barriers such as trade tariffs. It also requires a lot of resources to invest in the production of alternative goods.

In order to overcome these weaknesses, the government should negotiate trade agreements with its trading partners. Such agreements will help in eliminating trade barriers such as high tariffs which distort the prices of commodities (Maslen, 2011, pp. 34-46).

It is also important to finance the production of various commodities based on the revenues that they generate. Priority should be given to commodities that generate high and stable revenues.

Transparency and Sharing of Information

In most cases, the functioning of the commodity market is limited by lack of timely and comprehensive information about market conditions. The government should promote transparency and timely sharing of information about the supply and demand for commodities.

The regulators of the industries for various commodities can be given the responsibility of finding and making available information concerning market conditions such as prices, demand and supply. As the market moves towards equilibrium due to the availability of information, the prices will tend to be more stable and predictable (Boyes and Melvins, 2010, p. 78).

Legislation can also help in ensuring transparency in the various markets. The main advantage of this strategy is that it helps the market to move towards equilibrium which translates into stable prices. However, implementing this strategy requires a lot of capital to invest in modern information and communication technology.

Strengthening Social Safety Nets

Social safety nets are “non-contributory transfer programs seeking to prevent vulnerable citizens from falling below a certain poverty level” (Arnold, 2010, p. 90). As discussed above, commodity price volatility has the potential of increasing the level of national poverty by reducing consumers’ purchasing power. The government can respond to recession caused by commodity price volatility through the following programs.

It can transfer cash to the poor to enable them access basic commodities and services. The government can also subsidize the prices of basic commodities as well as production inputs (Arnold, 2010, p. 90). The justification of this strategy is that it will stimulate aggregate demand during recessions.

As the aggregate demand increases, prices are likely to rise thus improving the revenues received by producers (Arnold, 2010, p. 90). The consumers on the other hand will be able to access goods and services which they could have otherwise not been able to afford.

However, social safety nets are likely to fail if not well planned and implemented. This means that the government must correctly identify the most beneficial and cost effective strategy of providing the social safety nets.

Conclusion

Commodity price volatility refers to persistent fluctuation of the prices of various commodities over a given period. Such fluctuations have negative effects on the economic growth of a country if they are large and unpredictable. Commodity price volatility particularly causes a reduction in GDP growth rate. It also reduces the profitability of firms involved in the production and sale of various commodities.

As the profits fall, the level of investment reduces and unemployment rate increases (Arnold, 2010, p. 92). Canada has experienced large variations in the prices of its primary commodities since 2002. The variations are driven by both internal and external shocks as discussed above.

It is in the interest of the government of Canada to combat the problem of commodity price volatility since the primary commodity sector is a major source of income and investment in the country. This objective can be achieved by implementing the strategies discussed above.

References

Arnold, R. 2010. Macroeconomics. New York: Cengage Learning.

Barro, R. 2008. Macroeconomics. New York: Cengage Learning.

Boyes, W. and Melvins, M. 2010. Macroeconomics. New York: Cengage Learning.

Deepeshree, S. and Agarwal, V. 2006. Macroeconomics. New York: McGraw-Hill.

Krugman, P. 2009. Macroeconomics. New York: Worth Publishers.

Mankiw, G. 2002. Macroeconomics. Worth Publishers.

Maslen, G. 2011. In the Wake of the Boom. Economic Review, 10(1), 34-46.

Minh, V. 2011. Oil and Stock Market Volatility: A Multivariate Stochastic Volatility Perspective. Energy Economics, 33(2), pp. 956-965.

Moledina, A., Roe, T. and Shane, M. 2008. Measuring Commodity Price Volatility and the Welfare Consequence of Eliminating Volatility. Agricultural and Applied Economics, 3(2), pp. 798-812.

Murray, J. 2011. Commodity Prices: The Long and the Short of it. [Online] Web.

Pindyck, R. 2004. Volatility and Commodity Price Dynamics. Journal of Futures Markets, 24(11), pp. 1029-1047.

Varali, B. and Gabriel, P. 2009. What Explains High Commodity Price Volatility? Estimating a Unified Model of Common and Commodity-Specific Frequency Factors. Agricultural and Applied Economics, 2(1), pp. 67-72.

Verma, M. and Hertel, T. 2009. Commodity Price Volatility and Nutritional Vulnerability. Agricultural and Applied Economics, 3(1), pp. 405-415.

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