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Coping with Chile´s External Vulnerability: a Financial Problem

In: Economic Growth: Sources, Trends, and Cycles

  • Ricardo Caballero

    (Massachusetts Institute of Technology)

With traditional domestic imbalances long under control, the Chilean business cycle is driven by external shocks. Most importantly, Chile’s external vulnerability is primarily a financial problem. A decline in the Chilean terms of trade, for example, is associated to a decline in real GDP that is many times larger than one would predict in the presence of perfect financial markets. The financial nature of this excess-sensitivity has two central dimensions: a sharp contraction in Chile’s access to international financial markets when it needs it the most; and an inefficient reallocation of this scarce access across domestic borrowers during external crises. In this paper I characterize this financial mechanism and argue that Chile’s aggregate volatility can be reduced significantly by fostering the private sector’s development of financial instruments that are contingent on Chile’s main external shocks. As a first step, the Central Bank or IFIs could issue a benchmark instrument contingent on these shocks. I also advocate a countercyclical monetary policy but mainly for incentive —that is, as a substitute for taxes on capital inflows and equivalent measures— rather than for ex-post liquidity purposes.

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This chapter was published in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.) Economic Growth: Sources, Trends, and Cycles, , chapter 12, pages 377-416, 2002.
This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v06c12pp377-416.
Handle: RePEc:chb:bcchsb:v06c12pp377-416
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  1. Kenneth A. Froot, 1999. "The Financing of Catastrophe Risk," NBER Books, National Bureau of Economic Research, Inc, number froo99-1, October.
  2. Thorvaldur Gylfason & Gylfi Zoega, 2002. "Natural Resources And Economic Growth: The Role Of Investment," Working Papers Central Bank of Chile 142, Central Bank of Chile.
  3. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  4. Cummins, J. David & Lalonde, David & Phillips, Richard D., 2004. "The basis risk of catastrophic-loss index securities," Journal of Financial Economics, Elsevier, vol. 71(1), pages 77-111, January.
  5. Andrea Tokman Ramos, 2002. "Is Private Education Better? Evidence from Chile," Working Papers Central Bank of Chile 147, Central Bank of Chile.
  6. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
  7. Kenneth A. Froot, 1999. "Introduction to "Financing of Catastrophe Risk, The"," NBER Chapters, in: The Financing of Catastrophe Risk, pages 1-22 National Bureau of Economic Research, Inc.
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