Fiscal and Monetary Contraction in Chile: A Rational-Expectations Approach

46 Pages Posted: 20 Apr 2016

See all articles by Klaus Schmidt-Hebbel

Klaus Schmidt-Hebbel

Central Bank of Chile

Luis Servén

World Bank - Development Research Group (DECRG)

Date Written: June 1995

Abstract

To analyze the probable macroeconomic impact of fiscal and monetary retrenchment in Chile, an open-economy, dynamic rational-expectations macroeconomic model is applied to data for Chile.

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, Schmidt-Hebbel and Serven 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 between permanent 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.

This paper - a product of the Macroeconomics and Growth Division, Policy Research Department - is part of a larger effort in the department to model macroeconomic policy in developing countries.

Suggested Citation

Schmidt-Hebbel, Klaus and Servén, Luis, Fiscal and Monetary Contraction in Chile: A Rational-Expectations Approach (June 1995). World Bank Policy Research Working Paper No. 1472. Available at SSRN: https://ssrn.com/abstract=604908

Klaus Schmidt-Hebbel

Central Bank of Chile ( email )

Agustinas 1180
Santiago
Chile
(56-2) 670-2386, 670-2586 (Phone)
(56-2) 670-2836 (Fax)

Luis Servén (Contact Author)

World Bank - Development Research Group (DECRG)

1818 H. Street, N.W.
MSN3-311
Washington, DC 20433
United States

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