This paper builds a small open economy model for a net commodity exporter to consider financial frictions and monetary policies in order to investigate the main determinants of business cycles. Since we make a distinction to the access of financial markets between the commodity and non-commodity sectors, we notice that as usual, a commodity price shock benefits the competitiveness of the economy and its borrowing terms. We outline a novel effect in this paper which we dub the financial market effect following a positive commodity price shock that decreases the credit premium and hence exacerbate the commodity price boom. However the negative sectoral downturn affects entrepreneur credit together with disinflationary pressures of a real exchange rate appreciation. This opens the role for stabilization policies which we analyze comparing three types of monetary regimes. Estimating the model on South Africa, a major commodity exporting economy with inflation targeting regime, we .find as conventional wisdom suggests that a hypothetical Taylor rule targeting the price-level allows for adjustment in inflation expectations that can dampen disinflationary pressures. Furthermore, due to smoother change in nominal rate of interest, there is lesser variability in financial markets.
Monetary policy in a model with commodity and financial market