Exchange Volatility and Risk Premium

This paper empirically evaluates the importance of exchange rate regimes and exchange rate volatility on interest rate differentials, with special reference to Chile. We estimate risk-premia for 16 country experiences with different exchange rate regimes and then investigate whether these premia vary with volatility and the regime flexibility. When we assume that any diversifiable risk is actually traded and estimate a CAPM model augmented by taxes, we find a systematic but small relation between exchange rate volatility and risk-premium. In the case of Chile we do not find any significant impact of changes in exchange rate volatility on CAPM-estimated risk-premium. However, when we consider the overall effect of volatility on risk-premium and estimate an ARCH-M model we find a large effect of volatility on risk-premium in this country. In this set-up, when we analyze the cross-country experience, we do not find any relation between regime flexibility and risk-premium.

Optimal Monetary Policy Rules Under Inflation Range Targeting

We calculate and compare optimal monetary policy (MP) rules for a simple economy under alternative central bank objective (loss) functions. We compare both soft- and hard-edges range (zone) targeting as well as asymmetric loss-functions to a quadratic loss case. The latter represents the standard loss-function for point inflation targeting. The results show that MP aggressiveness under range targeting critically depends on how hard are the edges of this range. If a range is thought of as a thick point objective, MP is always active (there are no inaction zones), although it is less aggressive against inflation and output shocks if range edges are sufficiently soft (vis-à-vis a point target). Harder edges makes MP more aggressive even when the economy is close to the central part of the range. Finally, an asymmetric loss-function for inflation that penalizes positive deviations relatively more generates a bias against output.

Optimal Monetary Policy Rules when the Current Account Matters

This paper explores the implications for optimal monetary policy rules of including a target for the current account (CA) among central bank (CB) objectives. Using a simple but realistic macroeconomic model of the Chilean economy and standard dynamic programming with forward looking variables, the paper finds optimal rules under alternative specifications of a CB quadratic loss-function. The results show that optimal policy reactions change substantially when there is an objective for the CA (besides inflation). Furthermore, once the CA enters the CB objective function, the relative importance of output vis-à-vis inflation variability is less crucial in determining optimal policy rules. Using a simple 2-equation model, the paper then investigates the implications for monetary policy of having an asymmetric objective with respect to the CA. Specifically, it considers the case in which negative deviations from target are considered to be relatively more costly. The results indicate that, in this non-quadratic set-up, monetary policy is clearly more aggressive against positive inflation shocks than in the symmetric case.

Dedollarization, Indexation and Nominalization: The Chilean Experience

This paper revisits the Chilean experience with dollarization, indexation and nominalization in the 1958-2003 period. The purpose is to understand how Chile generally avoided dollarization and actually dedollarized in the 80s in order to draw some lessons for other countries. We find that many policies that Chile pursued are not easy to implement elsewhere. Some key characteristics of the Chilean process are related to initial institutional conditions and developments, whereas others are connected to macroeconomic performance and specific regulations. Indexation plays a key role in explaining how dollarization can be avoided.

Current Account and External Financing: An Introduction

Creation-DaThis brief review takes stock of the recent literature on current account and external financing and presents new analytical results and empirical research on the subject. Four key areas of related research are presented, namely global imbalances and macroeconomic adjustment; external adjustment in emerging economies, crises and current-account reversals; current account and exchange rate dynamics; and some policy issues concerning external financing. The review suggests a significant number of open questions, which were addressed in the thirteen groundbreaking papers presented at the Central Bank of Chile’s Annual Conference of 2006, which are summarized here.te:2007-12

Stocks, Flows and Valuation Effects of Foreign Assets and Liabilities: Do They Matter?

Large holdings of foreign assets and liabilities, along with increasing relevance of valuation effects—capital gains or losses—have characterized global financial integration. In this paper, we assess empirically the implications of stocks, flows and valuation adjustments in external crises (current-account reversals, sudden stops and currency crises), sovereign credit ratings and the longrun real exchange rates (RER), in both industrial and developing economies. We find support for the view that foreign assets and liabilities are rather distinctive external holdings with different implications in the occurrence of external crisis. Valuation adjustments have an impact on crises, although quantitatively not very large. Portfolio liabilities (particularly equity) increase the probability of current-account reversals and currency crises, while the likelihood of sudden stops increases with the stock of foreign direct investment (FDI) assets. In the case of sovereign credit ratings, we find a noteworthy effect of the stock and flows of FDI liabilities on improving sovereign ratings. Finally, as for the RER, gross assets and liabilities appear equally important, but components of external holdings have considerably different effects. While the cumulative current account is associated with real depreciation, the valuation effect is strongly linked with real currency appreciations in developing economies.

Labor Market Regulations and Income Inequality: Evidence for a Panel of Countries

This paper presents evidence on the impact of labor regulations on income inequality using two recently published databases on labor institutions and outcomes (Rama and Artecona, 2002; Botero, Djankov, La Porta, López-de-Silanes and Shleifer, 2003) and different cross-section and panel data analysis techniques for a sample of 121 countries over the 1970-2000 period. When we consider the techniques most likely to be robust, we find that: (i) de jure regulations do not improve income distribution; (ii) relative compliance with existing regulations improves income distribution; (iii) de facto regulations are weakly associated with improving income inequality. This result partly reflects the fact that regulations are endogenous and, more interestingly, different regulations have quite distinct effects. In particular, we find that any redistributive effect of labor regulations may come from trade union membership, public employment and mandated benefits (proxied by maternity leave).

Chile’s Fiscal Rule as Social Insurance

We explore the role of fiscal policy over the business cycle from a normative perspective, for a government with a highly volatile and exogenous revenue source. Instead of resorting to Keynesian mechanisms, in our framework fiscal policy plays a role because the government provides transfers to heterogeneous households facing volatile income, albeit with an imperfect transfer technology (a fraction of transfers leak to richer households). We calibrate the model to Chile’s highly volatile government revenues derived from copper, and characterize the optimal fiscal reaction. We quantify the welfare gains vis-à-vis a balanced budget rule, and the degree of adequate fiscal countercyclicality. We also analyze simpler rules, such as the structural balance rule in place in Chile during the last decade, more general linear rules, and linear rules with an escape clause. We find that the optimal rule leads to the same welfare gain as doubling the government’s copper revenues under a balanced budget rule. Chile’s structural balance rule achieves 18% of these gains, while a linear rule with an escape clause achieves 83% of the gains. The degrees of countercyclicality of the optimal rule and the linear rule with an escape clause are similar, and much larger than those of the structural balance rule.