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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.

Suggested Citation

  • Rodrigo Caputo, 2004. "Exchange Rates and Monetary Policy in Open Economies: The Experience of Chile in the Nineties," Working Papers Central Bank of Chile 272, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:272
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    References listed on IDEAS

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    1. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
    2. 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 315-323, October.
    3. Klaus Schmidt-Hebbel & Alejandro M. Werner, 2002. "Inflation Targeting in Brazil, Chile, and Mexico: Performance, Credibility, and the Exchange Rate," ECONOMIA JOURNAL, THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION - LACEA, vol. 0(Spring 20), pages 31-90, January.
    4. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 04/21, International Monetary Fund.
    5. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    6. 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.
    7. 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.
    8. Favero, Carlo A., 2001. "Applied Macroeconometrics," OUP Catalogue, Oxford University Press, number 9780198296850.
    9. 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.
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    Cited by:

    1. Marcelo Sanchez, 2008. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," International Economic Journal, Taylor & Francis Journals, vol. 22(1), pages 43-61.
    2. Sánchez, Marcelo, 2005. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," Working Paper Series 548, European Central Bank.

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