By impinging on individuals’ wealth, due to the impact of higher relative prices on current and expected future income, commodity price shocks may trigger a reduction in the demand for goods and services. For given potential output growth, the wealth effect would give rise to excess aggregate supply, thereby leading to downward pressure on domestic inflation.
Whether inflation tends to increase or fall in response to an adverse terms-of-trade shock will therefore depend on which of these two effects dominates. In theory, there is no general result. The net effect will also depend on specific features of the shock, e.g.