1 April 20-21, 2006 The Real Exchange Rate in Chile Rodrigo O. Valdés Central Bank of Chile XXIII Meeting of the Latin American Network of Central Banks and Finance Ministers

2 Four Bottom Lines C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E 1.There has been substantial peso appreciation, but not particularly unusual in a historical perspective. 2.(Current) Changes in fundamentals can explain a large XR movement:  Theoretically  Empirically 3.Obvious public concerns reflect the different jobs the XR performs in a small open economy. 4.Policy responses have mitigated the peso appreciation.

3 Is It the Peso, the Dollar or Both? C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E

4 Real Exchange Rate in Chile: A Longer Perspective C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Source: Central Bank of Chile

5 Real Exchange Rate in Chile: A Very Very Long Perspective Source: Updated from Calderón and Duncan (2003) C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E

6 An Obvious Suspect: Large Swings in Fundamentals Source: Central Bank of Chile C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E

7 Suspects Fit in Theory RER response to a permanent 10% increase in copper price under alternative specifications of MAS, a DSGE Model of the Chilean economy C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Source: Soto and Medina (2005a)  MAS: microfounded DSGE model for the Chilean economy.  Commodity sector that takes prices as given, important share of government in commodity sector, sector demands capital, government expenditure bundle has more non traded goods.  Imperfect pass-through, sticky prices, and wages indexed to past inflation. Imperfect capital mobility.  Policy rule for the real interest rate.

8 Suspects Fit in Theory (cont.) MAS responses to a transitory 10% increase in copper price C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Source: Soto and Medina (2005b )

9 Suspects Fit Empirically – High Frequency Analysis C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Source: Selaive (2006)

10 Suspects Fit Empirically – Quarterly BEER Model C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Source: Caputo and Dominichetti (2005)

11 Is It a Public Concern? C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E

12 Behind the Concerns C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E The XR has at least three jobs: (i)Relative price signal to soften the cycle (ii)Relative price signal to foster X-led growth (iii)Signal to correctly price risks and limit vulnerability Some issues:  For (iii) need some ex ante volatility  (i) and (ii) mix well in bad times, but not in good ones  Transitory, permanent and long-lasting shocks  Policies have different comparative advantages in affecting these jobs.

13 Policy Responses I C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Fiscal Policy:  Structural surplus fiscal rule indicates that 100% of excess revenues are saved (2005 surplus = 4.8% of GDP)  Not spending can have major effects (Example: )  Current challenge: financial management of these surpluses.

14 Policy Responses II C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Monetary and XR Policy:  Full-fledged IT + free floating XR renders a natural buffer, as monetary policy is contingent.  When XR is off what the authorities consider as fair valuation they may hint it:  January Monetary Policy Report baseline scenario included a “ moderate depreciation ” and an assessment of long run RER.  “ Verbal ” intervention through public statements.  Intervention is part of the toolbox. Need to spot misaligment, evaluate that it is costly and that intervention has a chance of success.

15 Fiscal Rule and a ToT Shock C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E Responses to a 4% increase in government income (Source: Garc í a and Restrepo, 2006)

16 References C E N T R A L B A N K O F C H I L E R E A L E X C H A N G E R A T E I N C H I L E  Calderón C. and R. Duncan (2003), “ Purchasing Power Parity in an Emerging Market Economy: A Long-Span Study for Chile, ” WP N°215, Central Bank of Chile, June.  Caputo, R. and B. Dominichetti (2006), “ Revisi ó n Metodol ó gica en el C á lculo del IPE e Implicancias sobre los Modelos de Series de Tiempo para el TCR, ” Economia Chilena, Vol.8 N°1, Central Bank of Chile, April.  García C. and J. Restrepo (2006), “ The Case for a Countercyclical Rule-based Fiscal Regime, ” mimeo, Central Bank of Chile.  Selaive, J. (2006), “ Nominal Exchange Dynamics in Chile, ” mimeo in progress, Central Bank of Chile.  Soto, C. and J.P. Medina (2005a), “ Proyecto MAS: Modelo para An á lisis y simulaciones, ” mimeo, Central Bank of Chile.  Soto C. and J.P Medina (2005b), “ MAS: A New DSGE Model for the Chilean Economy, ” mimeo, Central Bank of Chile.