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Capital flows and long-term equilibrium real exchange rates in Chile


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  • Elbadawi, Ibrahim A.
  • Soto, Raimundo


In the context of an empirical model, the authors examine the impact of capital flows, among other fundamentals, on long-term exchange rates in Chile. The real exchange rate and its fundamentals were found to be cointegrated during 1960-92. This cointegration allows a reinterpretation of uni-equatorial estimates of the equilibrium real exchange rate (ERER) to be consistent with long-run forward-looking behavioral models. It also permits the estimation of an error-correction model capable of disentangling short-run from long-run shocks in observed movements of the ERER. The nonstationary nature of the fundamentals allows one to decompose innovations into permanent and transitory components - to get an empirical measure of the sustainability of the fundamental with which the ERER is determined. In general, the estimate of the cointegration of the ERER and its corresponding dynamic error-correction specification corroborates the theoretical model and produces fairly consistent results. The derived ERER index and the corresponding real exchange rate misalignment (for given sustainable values of the fundamentals) successfully reproduce the salient episodes in Chile's recent macroeconomic history. Capital flows are disaggregated into four components: 1) short-term capital flows; 2) long-term capital flows; 3) portfolio investment; and 4) foreign direct investment. As expected from economic theory, short-term capital flows and portfolio investment were found to have no effect on the ERER (although they can affect the real exchange rate in the short run). But long-term capital inflows and foreign direct investment have a significant appreciating effect on the ERER. To the extent that the recent inflow of capital to Chile is dominated by long-term capital flows that are judged to be sustainable, an important part of the ensuing appreciation of the real exchange rate is consistent with equilibrium behavior - reducing the need for counterbalancing exchange rate on macroeconomic policies.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1306.

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Date of creation: 30 Jun 1994
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Handle: RePEc:wbk:wbrwps:1306

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Keywords: Economic Stabilization; Environmental Economics&Policies; Achieving Shared Growth; Economic Theory&Research; Macroeconomic Management;


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  1. Rodriguez, Carlos Alfredo, 1989. "Macroeconomic policies for structural adjustment," Policy Research Working Paper Series 247, The World Bank.
  2. Mundlak, Yair & Cavallo, Domingo & Domenech, Roberto, 1989. "Agriculture and economic growth in Argentina, 1913-84:," Research reports, International Food Policy Research Institute (IFPRI) 76, International Food Policy Research Institute (IFPRI).
  3. Schmidt-Hebbel, Klaus & Serven, Luis & DEC, 1994. "Dynamic response to external shocks in classical and Keynesian economies," Policy Research Working Paper Series 1300, The World Bank.
  4. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1993. "“Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," MPRA Paper 7125, University Library of Munich, Germany.
  5. Campbell, John & Perron, Pierre, 1991. "Pitfalls and Opportunities: What Macroeconomists Should Know about Unit Roots," Scholarly Articles 3374863, Harvard University Department of Economics.
  6. Campbell, John Y & Mankiw, N Gregory, 1987. "Permanent and Transitory Components in Macroeconomic Fluctuations," American Economic Review, American Economic Association, American Economic Association, vol. 77(2), pages 111-17, May.
  7. Obstfeld, Maurice, 1983. "Intertemporal price speculation and the optimal current-account deficit," Journal of International Money and Finance, Elsevier, Elsevier, vol. 2(2), pages 135-145, August.
  8. Sebastian Edwards, 1985. "The Behavior of Interest Rates and Real Exchange Rates During a Liberalization Episode: The Case of Chile 1973-83," NBER Working Papers 1702, National Bureau of Economic Research, Inc.
  9. Patricio Arrau & Jorge Quiroz & Rómulo Chumacero, 1992. "Ahorro Fiscal y Tipo de Cambio Real," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 29(88), pages 349-386.
  10. Granger, C. W. J. & Newbold, P., 1974. "Spurious regressions in econometrics," Journal of Econometrics, Elsevier, Elsevier, vol. 2(2), pages 111-120, July.
  11. Corbo, Vittorio, 1985. "International Prices, Wages and Inflation in an Open Economy: A Chilean Model," The Review of Economics and Statistics, MIT Press, vol. 67(4), pages 564-73, November.
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