A Chile in Transition: Stability Brings Change. Macroeconomics 556 April 13, Alex Rosaen Neerav Shah Elias Walsh

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1 A Chile in Transition: Stability Brings Change Macroeconomics 556 April 13, 2005 Alex Rosaen Neerav Shah Elias Walsh

2 Since 1996 Chile has enjoyed declining inflation and stable growth. Government has been spending more on education and heath care, an investment in the future of the country. This steady course persisted even through an economic crisis in its next-door neighbor, Argentina. Some of the county s success can be attributed to high copper prices, a major export. This alone, however, cannot explain the recent economic trends. Chile s central bank has used monetary policy wisely, and the country is reaping the benefits. First, the Central Bank successfully used a crawling band exchange rate to ensure that inflation was brought under control. Once this was achieved, the Bank decided to float the Peso. While this could have had significant negative effects for the economy, particularly for investment and unemployment, the Central Bank again used monetary policy to maintain the confidence of the public and of investors. Chile is likely to continue its success, but some vulnerabilities do exist. In particular, if copper prices fall, Chile may need to tighten its belt. 1999: Abandoning the Crawl Prior to 1999 Chile utilized a crawling band to peg its exchange rate to a basket of currencies (US$, Yen, and the Mark) 1. Such a band limited the ability of Chile s Central Bank to use monetary policy. Any monetary action would lead to changes in the price of a Peso on the world market, thus altering the exchange rate. A change in the exchange rate beyond the limits of the currency band would force the monetary authority to reverse much or all of their initial action. 1 Felipe G. Morande. Exchange Rate Policy in Chile: A Recent Experience, Accessed On-line: April 11,

3 However, the crawling band did force the Central Bank to check inflation. Heading into the 1990s Chile faced 20% annual inflation. By 1998 annual inflation had fallen to just 5% (Fig. 1). Despite the apparent success of the crawling band, some in the Central Bank were pushing for change prompting a number of amendments to the crawling band. In particular, the size of the band had been steadily increasing over time 2. A wider band is a step in the direction of a more flexible exchange rate. With a more flexible exchange rate the Chilean Central Bank had more freedom to use monetary policy. While such freedom might be desirable, it also means that the exchange rate could be allowed to fluctuate more. Figure 2 shows trends in the value of the U.S. Dollar and of the Chilean Peso. The graph shows that in fact the Peso tracks the Dollar quite closely (in terms of relative appreciations and depreciations) up through This suggests that while the Central Bank may have had more freedom to use monetary policy as the band widened, they apparently chose not to use it. Even so, Chile eventually decided to float the Peso. This idea made some in the Central Bank nervous, even as inflation seemed under control. The crawling band was, in part, an effort to inspire the confidence that strict adherence to the band gave investors: a crawling exchange rate band, no matter how amended and discredited, was instrumental to signal a long term commitment to a certain value of the real exchange rate, wrote Felipe Morande, former Chief Economist of the Central Bank of Chile. If investors 2 Felipe G. Morande. Exchange Rate Policy in Chile: A Recent Experience, Accessed On-line: April 11,

4 thought that the Central Bank might use their new freedom unwisely, then the economy could contract as investment fell. Another fear was the effect on unemployment. Under the crawling band expected inflation was kept quite low. If floating the Peso led the public to believe annual inflation might rise, then the Phillips model predicts that unemployment would rise as well. This is because a rise in expected inflation will shift the Phillips curve outward (Fig. 3). Chile had to be certain that floating the Peso would not result in the loss of public confidence in the Central Bank or be ready to face large increases in unemployment. Thus, when the Central Bank decided to float the Peso in 1999, they simultaneously contracted the money supply (Fig 4). As a result interest rates shot up and output declined slightly due to drops in investment and consumption (Fig. 5). This temporary decline was intended as a strong signal to the public that the Central Bank would continue to keep inflation in check. Using the Phillips model, the unemployment level can provide some evidence about whether the Central Bank succeeded in preventing a rise in expected inflation. Since inflation continued to fall over this period somewhat higher unemployment is expected even holding expected inflation constant (a shift along a Phllips curve). This small increase in unemployment would then be unrelated to public confidence. But if the Central Bank fails to prevent a rise in expected inflation then unemployment could skyrocket when the change is made. In fact, it is difficult to interpret what we see in

5 Figure 6. The unemployment rate does rise from under 6% to over 8%, but, as above, this rise is consistent with constant levels of expected inflation, i.e. the rise could be a movement along a Phillips curve rather than a shift out of the curve. The data does not provide strong evidence for a significant rise in expected inflation. A two to three percentage point increase in unemployment is, however, a significant cost of the policy, none-the-less. In the years since the shift to a floating Peso interest rates have fallen, and inflation has remained at a low and steady rate. This suggests that the Central Bank was successful at winning itself more freedom to use monetary policy while maintaining credibility among investors and the public. Vulnerabilities Despite the 2001 crisis endured by its neighbor Argentina, Chile has enjoyed macroeconomic stability in recent years. Thus, Chile's highest priority macroeconomic problems are potential vulnerabilities rather than present challenges. A crisis in another emerging country is one sensible place to look for worries. However, Chile demonstrated that it could weather the Argentina crisis in 2001 relative serenity (Fig. 5). This is evidence that the competence and discipline of Chile's fiscal and monetary policies around and after the 1999 float of the peso has given the markets more confidence in Chile than other emerging markets. Thus, while an emerging-market crisis

6 might be a small threat to investor confidence and the real exchange rate, it is not the most pressing problem. A more pressing worry is the possibility of an exogenous shock to output, contracting the economy through movement of the IS curve. One plausible scenario is a sharp drop in the price of copper, the sale of which accounts for 45% of Chile's export earnings. The current near-all-time-high price of copper (over USD1.50/lb), has helped Chile to amass large current account surpluses and foreign exchange reserves, and has allowed it to maintain its policy of fiscal surpluses while modestly expanding spending on health and education. A reversal of fortunes in copper would be a painful turn of events. In response to a fall in commodity prices, Chile would be forced to contract the money supply in order to remain in balance of payments. This would lead to a decline in output. However, since Chile has adopted a floating exchange rate policy, the contraction would not need to be as large as it would have been under a less flexible policy. Thus, barring a long-term drastic change in the price of copper, Chile is in a good position to weather the storm. Other scenarios that could lead to an exogenous shock to output include a sharp decline in the US dollar (reducing demand for Chilean exports, aside from copper, such as wine, fruit, and paper products), and similar effects from a more general global economic slowdown.