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Exchange Rates and Monetary Policy in Open Economies: The Experience of Chile in the Nineties

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  • Rodrigo Caputo

Abstract

This paper provides an empirical characterization of the conduct of monetary policy in a small open economy. In particular, using as a case study the Chilean inflation-targeting experience of the nineties, we assess the roles of the exchange rate and output in the determination of the policy interest rate. We conclude that Chile adopted a gradual approach to targeting inflation. This means, in practice, that the central bank modified its policy instrument —the interest rate— whenever expected inflation deviated from its target, but with some concern about output. In this context, we find evidence that the monetary authorities also reacted to real exchange rate misalignments. This reaction was comparatively larger than the one found in developed economies. Finally, the evidence, although not conclusive, suggests that there was a non-linear response to exchange rate misalignments: the central bank reacted more strongly to large deviations than to small ones.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 272.

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Date of creation: Oct 2004
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Handle: RePEc:chb:bcchwp:272

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  1. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
  2. Favero, Carlo A., 2001. "Applied Macroeconometrics," OUP Catalogue, Oxford University Press, number 9780198296850.
  3. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  4. Klaus Schmidt-Hebbel & Alejandro Werner, 2002. "Inflation Targeting in Brazil, Chile, and Mexico: Performance, Credibility, and the Exchange Rate," Working Papers Central Bank of Chile 171, Central Bank of Chile.
  5. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
  6. Oscar Landerretche & Felipe Morandé & Klaus Schmidt-Hebbe, 1999. "Inflation Targets and Stabilization in Chile," Working Papers Central Bank of Chile 55, Central Bank of Chile.
  7. Clarida, Richard H, 2001. "The Empirics of Monetary Policy Rules in Open Economies," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 6(4), pages 315-23, October.
  8. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 04/21, International Monetary Fund.
  9. Schmidt-Hebbel, Klaus & Tapia, Matias, 2002. "Inflation targeting in Chile," The North American Journal of Economics and Finance, Elsevier, vol. 13(2), pages 125-146, August.
  10. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
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