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Fiscal and monetary contraction in Chile : a rational-expectations approach

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  • Schmidt-Hebbel, Klaus
  • Serven, Luis

Abstract

For the past two decades, Chile has consistently pursued a course of macroeconomic stabilization and deep economic reform. But in recent years, real exchange rate appreciation and persistent moderate inflation have become key concerns for Chilean policymakers, suggesting the need for further fiscal and monetary retrenchment. Using an open-economy, dynamic rational-expectations macroeconomic model applied to Chile, the authors analyze and quantify the macroeconomic impact of fiscal and monetary retrenchment. Several features of the model are essential for a realistic assessment of the effects of fiscal and monetary policy shifts in Chile: backward indexation of wages, consolidation of the central bank and the general government, and the coexistence of (1) liquidity-constrained consumers and firms with (2) unconstrained agents whose consumption and investment decisions reflect intertemporal optimization with perfect foresight. This framework makes it possible to distinguish meaningfully betweenpermanent and transitory policy changes, as well as between changes that are or are not anticipated. Simulations show that a balanced-budget fiscal contraction leads to a modest real depreciation, which is sharper in the short term (especially if the contraction is temporary). At the same time, this type of fiscal retrenchment causes a temporary deterioration of the current account. An orthodox money-based disinflation implemented by halving the growth rate of base money leads to a sharp real appreciation in the near term, with steep output and employment costs in the short run, but it also causes a transitory improvement in the current account.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1472.

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Date of creation: 30 Jun 1995
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Handle: RePEc:wbk:wbrwps:1472

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Keywords: Environmental Economics&Policies; International Terrorism&Counterterrorism; Fiscal&Monetary Policy; Economic Theory&Research; Payment Systems&Infrastructure; Macroeconomic Management; Banks&Banking Reform; Economic Theory&Research; Environmental Economics&Policies; Economic Stabilization;

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  1. Buiter, Willem H, 1984. "Saddlepoint Problems in Continuous Time Rational Expectations Models: A General Method and Some Macroeconomic Examples," Econometrica, Econometric Society, Econometric Society, vol. 52(3), pages 665-80, May.
  2. Giavazzi, Francesco & Odekon, Mehmet & Wyplosz, Charles, 1982. "Simulating an oil shock with sticky prices," European Economic Review, Elsevier, Elsevier, vol. 18(1), pages 11-33.
  3. Olivier J. Blanchard, 1984. "Debt, Deficits and Finite Horizons," NBER Working Papers 1389, National Bureau of Economic Research, Inc.
  4. Hayashi, Fumio & Inoue, Tohru, 1991. "The Relation between Firm Growth and Q with Multiple Capital Goods: Theory and Evidence from Panel Data on Japanese Firms," Econometrica, Econometric Society, Econometric Society, vol. 59(3), pages 731-53, May.
  5. Elbadawi, Ibrahim A. & Soto, Raimundo, 1994. "Capital flows and long-term equilibrium real exchange rates in Chile," Policy Research Working Paper Series 1306, The World Bank.
  6. B. Douglas Bernheim, 1988. "Ricardian Equivalence: An Evaluation of Theory and Evidence," NBER Working Papers 2330, National Bureau of Economic Research, Inc.
  7. 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.
  8. Schmidt-Hebbel, Klaus & Serven, Luis, 1994. "Fiscal policy in classical and Keynesian open economies," Policy Research Working Paper Series 1299, The World Bank.
  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. Warwick J. McKibbin & Jeffrey D. Sachs, 1989. "The McKibbin-Sachs Global Model: Theory and Specifications," NBER Working Papers 3100, National Bureau of Economic Research, Inc.
  11. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, Econometric Society, vol. 48(5), pages 1305-11, July.
  12. Treadway, Arthur B, 1969. "On Rational Entrepreneurial Behaviour and the Demand for Investment," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 36(106), pages 227-39, April.
  13. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  14. Turnovsky, S.J. & Sen, P., 1990. "Fiscal Policy, Capital Accumulation, And Debt In An Open Economy," Discussion Papers in Economics at the University of Washington, Department of Economics at the University of Washington 90-18, Department of Economics at the University of Washington.
  15. Seater, John J, 1993. "Ricardian Equivalence," Journal of Economic Literature, American Economic Association, vol. 31(1), pages 142-90, March.
  16. Serven, Luis, 1995. "Capital goods imports, the real exchange rate and the current account," Journal of International Economics, Elsevier, Elsevier, vol. 39(1-2), pages 79-101, August.
  17. McKibbin, W.J. & Wilcoxen, J.P., 1992. "G-Cubec: A Dynamic Multi-Sector General Equilibrium Model of the Global economy (Quantifying the Cost of Curbing CO2 Emissions)," Papers, Brookings Institution - Working Papers 98, Brookings Institution - Working Papers.
  18. Serven, Luis & Solimano, Andres, 1991. "An empirical macroeconomic model for policy design : the case of Chile," Policy Research Working Paper Series 709, The World Bank.
  19. Fair, Ray C & Taylor, John B, 1983. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear Rational Expectations Models," Econometrica, Econometric Society, Econometric Society, vol. 51(4), pages 1169-85, July.
  20. repec:fth:coluec:519a is not listed on IDEAS
  21. R. Glenn Hubbard & Kenneth L. Judd, 1986. "Liquidity Constraints, Fiscal Policy, and Consumption," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 17(1), pages 1-60.
  22. Mckibbin, W.J. & Sundberg, M.W., 1990. "Macroeconomic Linkages Between The Oecd And The Asia-Pacific Region," Papers, Brookings Institution - Working Papers 80, Brookings Institution - Working Papers.
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