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

Klaus Schmidt-Hebbel and Luis Servén

No 1472, Policy Research Working Paper Series from The World Bank

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.

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 (search for similar items in EconPapers)
Date: 1995-06-30
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