Policy, Research; and External Affairs
WORKING PAPERS
Macroeconomic Adjustment
M and Growth
Country Economics Department
The World Bank
June 1991
WPS 709
An Empirical
Macroeconomic Model
for Policy Design
The Case of Chile
Luis Serven
and
Andres Solimano
A model focusing on the design and evaluation of macroeco-
nomic policy is applied to Chile.
ThePobly,Research, and l'xtemal Affairs Complex distnbutes PRIE WorkingPapers todisseminate the findungs of work inprogress and
to encourage the exchange of ideas among Bank stalf and all others interested in development issues. These papers carry the names of
the authors, renect only their views, and should be used and cited accordingiv. T'he findungs, interpretauons, and conclusions are the
authors' own. They should not be atLnbuted to the World 13ank, its 13oard of Directors, its management, or any of its member counuies.
Policy, Research, and External Affairs
Macroeconomic Adjustmn
and G:rowth
* J
WPS 709
This paper -a product of the Macroeconomic Adjustment and Growth Division, Country Economics
Department --- is part of a larger effort in PRE to design applicd macroeconomic models for the evaluation
of mnacroeconomic policies. Copies are available free from the World Bank, 1818 H Street NW,
Washington DC 20433. Please contact Susheela Jonnakuty, room N 1 1-039, extension 39074 ( 79 pagcs,
with figu. i, graphs, and tables).
Serven and Solimano construct, estimate, and consistent framework, the modcl adds behavioral
simulate a macroeconomic model for Chile. equations with sound analytical foundations.
This model allows aggregate supply and demand
factors to interact in determining such key Serven and Solimano use model simulations
economic variables as inflation, the real wage, to explore the effects of domestic policies and
the real exchange rate, real output and employ- external shocks (like a balanced-budget fiscal
ment, and the current account balance. expansion, a policy of increased growth in
minimum wages, a fall in world copper prices,
The model ensures the consistency of and an oil price shock). These simulations help
different aggregates by imposing the relevanit illustrate the effects of economic policies and
budget constraints on the fiscal sector, the ecntral external factors that shape current policy discus-
bank, and the balance of payments. To this sions in Chile.
The PRE Working Paper Scries disseminates the findings of work under way in the Bank's Policy, Research, and Extemal
AffairsComplex. An objective of the scxies is to get these findings out quickly, even if presentations are less than fully polished.
The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.
Produced by the PRE Dissemination Center
TABLE OF CONTENTS
1. Introduction ........... .... ... .... .... . 1
2. The Chilean Economy in the 1980s: an Overview . . . . . . . . . . . 3
3. The Analvtical Model . . . . . . . . . . . . . . . . . . . . . . . 14
4. Empirical Results ........................ . 35
5. Out-of-Sample Policy Simulations ................. . 48
6. Final Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
TABLES
FIGURES
* We thank Bela Balassa, Vittorio Corbo, Stanley Fischer, John Holser,
Johannes Linn, seminar participants at ILADES. and our colleagues at CECMG for
useful comments on previous versions of this paper. Jorge Castillo, Raul
Laban, Fernando Quevedo and Rodrigo Vergara provided efficient research
assistance.
1. Introduction
The design and implementation of macroeconomic policies requires, among
other things, a clear understanding of the rules of macroeconomic behavior and
the budget constraints that relate macro variables. The development of
empirical macroeconomic models incorporating an adequate representation of
such relationships may be a useful tool for policy-makers and scholars
interested in macroeconomic policy. In the past fifteen years, empirical
macro modelling has suffered two lines of criticism: on the one hand,
traditional macroeconometric models have been criticized on the grounds that
their theoretical underpinnings are weak and because of their lack of solid
rmicrofoundations. A second line of criticism focuses on the fact that the
"structural" parameters of econometric models are in fact not policy-invariant
and therefore their use may lead to potentially misleading model-based policy
prescriptions and evaluation. This paper takes the view that in spite of the
validity of some of these ctiticisms, there is still room for theoretically-
grounded, empirically relevant, macroeconomic modelling.
Hacro modelling may be very useful in three respects. First, it
provides a conceptual framework organized around accounting identities and
behavioral relationships that can help in the uno'erstanding of macroeconomic
problems. Second, empirical macro models provide a quantitative tool for
assessing the orders of magnitude of the impact of different policies on the
main variables that are of interest in the conduct of macroeconomic policy.
And third, the models can help assess the consistency between targets of macro
policy such as low inflation, external balance and sustainable growth, the
setting of policy instruments for monetary, fiscal and exchange rate policy
and the level of certain key relative prices such as the real exchange rate,
the real interest rate and the real wage.
In this paper we set up a macroeconomic model for an open economy in
wnich both aggregate demand and aggregate supply play a role in the
determination of the key macroeconomic variables -- output, employment the
rate of inflation, the real exchange rate and the real interest rate. The
model is estimated with annual data for the Chilean economy and used for the
2
simulation of macro policies in the 1990s.
The analytical model considers the gooda market, the labor market, and
assets markets. Goods market clearing determines the real exchange rate. Among
the components of goods demand, private consumption anu investment as well as
exports and imports are endogenously determined. Aggregate demand depends on
current end permanent income, the real interest rate and fiscal parameters;
and on the real exchange rate and foreign demand. Aggregate supply of
domestic goods depends on real wages and also on the real exchange rate, due
to the use of imported intermediate inputs in the production process.
In turn, the 'Labor market need not clear in the short run, due to wage
inertia. The wage-exchange rate-price mechanism is also an important part of
the model. In particular, our framework intends te capture the impact of wage
indexation and exchange rate rules on the dy,.amics -- and, especially the
inertia -- of inflation.
Finally, the model ensures consistency by explicitly incorporating three
crucial constraints for the conduct of macroeconomic policy: the fiscal
constraint, the balance of payments, and the money supply identity.
The plan of the paper is as follows. Section 2 provides an overview of
the Chilean economy in the 19808 in order to set the stage for understanding
some macro policy choices envisaged for the 1990s. The analytical structure
of the model is presented in section 3. The results of the econometric
estimation are presented in section 4. In section 5 the model is used to :
perform a set of policy simulations for the period 1990-1995. A base
simulation is constructed in order to have a benchmark case to which compare
the policy simulations. The paper closes with some final remarks in
section 6.
2. The Chilean Economy in the 1980s: An Overview'
The behavior of the Chilean economy during the eightias can be
characterized by three clearly distinguished periods. The first one was
This section draws from Solimano (1990a).
3
associated with an exchange rate based stabilization program following the
fixing of the exahange rate from mid-1979 to mid-1982. In that period
inflation sta-ilization was pursued through the management of exchange rate
policy, and an unsustainable debt-led boom in economic activity developed,
fueled by external borrowing. A second period comes in 1982-1983 where a
severe recession and a financial crisis set in associated with previous policy
mistakes and advertse external shocks. Finally, after 1984 emerges a period of
recovery and growth based in strong export performance and the recovery of
investment in a context of macroeconomic stability, impaired at the end of the
1980s by an unwarranted demand expansion.
2.1 Exchange rate based stabilization: 1979 82
This period is characterized b- a failed attempt at exchange rate-based
stabilization that begins ir- June 1979 when, after a moderate stepwise
devaluation, the exchange rate was fixed for an undetermined period of time in
order to curb inflationary expectations and bring domestic Inflation to
international levels. The absence of fiscal imbalances and a low (and
uniform) tariff structure were regarded as atrong backers of the exchange rate
policy. Ultimately, the experiment had to be abandoned in June 198g Len the
exchange rate was finally devalued in the midst of a severe recession and
worsened extern 1 conditions.
This period was one of booming economic activity, rising real wages and ;
overexpanding financial intermediation in a context of heavy foreign
borrowing. Severe misalignments in some key relative prices and foreign and
domestic overindebtedness rendered the economy particularly vulnerable to
adverse external and internal shocks. In fact the real exchange rate
appreciated and unsustainable current accounts deficits developed -- up to
14.52 of GDP in 1981 -- as exports started to be squeezed and imports boomed.
In turn, high domestic real interest rates, mainly in 1981, seeded an incoming
financial crisis as the path of internal debt accumulation by domestic firms -
and households with the financial system (the counterpart of heavy foreign
4
borroW.ng) reached unsustainable levels.
2.2 The crisie of 1982-83
During 1982-1983, the Chilean economy experienced a severo recession as
a consequence of negative external shocks and previous domestic policy
miGtak,s2. After an attempt to correct the large external imbalance developed
in 1981, through tight money and high real interest rates (without devaluing
the exchange rate), by mid-1982 the government changed its policy and decided
to correct the exchangie rate overvaluation by a series of 1iscrete
devaluations followed by a crawling peg. Fiscal and monetary policies were
clearly restrictive to support the exchange rate policy and reduce domestic
absorption. As a result of these policies and the external shocks, CDP fell
by around 1. percent in 1982-83, imports were cut by half in real terms in
those two years, investment collapsed and open unemployment rates climbed to
nearly 20 percent. The sharp drop in economic act vity during 1982-83 was
complicated by the financial situation of many indebted firms as they started
to face the coa4unction of large debts and depressed demand. As a result, the
financial sector was in a very fragile shape with an important part of the
loans of the major financial institutions becoming non-performing. The
banking crisis further curtailed the supply of domestic credit in the economy,
forcing ultimately the Central Bank to intervene several firnncial
institutions and undertake massive rescue operations and, in some cases,
liquidation.
2.3 The opriod of recovery and growth after 1984
A phase of recovery and growth takes place after 1984. In 1984-89 GDP
grew at an impressive 6.3 per year, and inflation averaged 20.4 percent per
annum, a low level for Latin American standards. In addition, such growth bqs
taken place in the context of reduced reliance on external savings (see the
2 There is an already vast literature on that period for the Chilean case,
see Arellano (1988), Corbo (1985), Edwards and Edwards (1987), Foxley (1982).
reduction In the current account deficits in Taole 1) and consolidation of
Internal financial stability. Looking at this porformance some important
questions arises First, what ate the sources of growth in the Chilean economy
in this period? Is .he current growth record sustainable over time? What
6
Table 1. Macroeconomic Indicators for Chile: 1980-89
GDP Inflation Fiscal Current Real Real Terms of Average Real
growth rate Deficit1 Account Exchange Interest TradA Real Minimum
(2) (2) Z of GDP Deficit Rate rate (Z) (1980=100) WaLes Wages
(S) (1980=100) (90-365
da s8)
(1) (2) (3) (4) (5) (6 (7) (8) (9)
1980 7.8 31.2 -3.1 7.1 100.0 8.4 100.0 100.0 100.0
1981 5.5 9.5 -1.7 14.5 90.9 13.2 84.3 108.9 115.7
1982 -14.1 20.7 2.3 9.5 108.8 12.1 80.4 108.6 117.2
1983 -0.7 23.1 3.8 5.7 135.6 7.7 87.5 97.1 94.2
1984 6.3 23.0 4.0 10.7 144.1 8.4 83.2 97.2 80.7
1985 2.4 7 .4 6.3 8.3 179.4 8.2 78.5 93.5 76.4
1986 5.7 17.4 2.8 6.5 175.5 4.1 79.0 95.1 73.6
1987 5.7 21.5 0.1 4.3 170.8 4.2 83.0 94.? 69.1
1988 7.4 12.7 1.7 0.8 181.9 4.6 100.0 101.0 73.4
1989 10.0 21.1 -3.0 3.0 177.5 6.8 105.0 102.9 79.7
Source: Boletin Mensual Banco Central de Chile. Various Issues.
CEPAL (1989) Informe Preliminar de la Economia de America Latina, el Caribe. Naciones Unidas.
" minus indicates surplus.
7
explains the fact that thb recovery of economic activity in Chile has been
non-inflationatl.(by Latin American standards) in circumstances that the
exchange rate has depreciated over 45 percent. in real terms, in the last six
years and a financial crisis led monetary authorities to reshuffle major
financial intermediaries? To which extent the benefits from higher growth have
been shared by labor and other low income groups?
2.3.1 Sources of recovery and growth after 1984
An important fact that table 2 shows is that the recovery in Chile since
1984 has been driven mostly by exports and investment, rather than by
consumption growth. In fact, the average rate of growth of total exports has
been 8.9 percent per year in the period 1984-89 whereas the rate of growth of
aggregate consumption has averaged 4.2 per year over the same period.
Investment has been growing at an average rate of 25 percent per year chough
with large fluctuations over the period; nevertheless, this percentage is
strongly affected by 1984 and 1989, when the growth in gross investment seems
to reflect, to a considerable extent, the building up of inventories. Anyway,
as a share of GDP, investment has recovered from a low of 13.6% in 1984 to 22
percent in 1989. Moreover, exports also have increased their share of GDP
while the share of total consumption hab declined.
What explairs the rapid increase in exports, investment and growth in
the last six years? exchange rate policy has played a preeminent role in the
expansion of exports and import competing activities in that period. A higher
and relrtively stable real exchange rate has increased the profitability of
8
Table 2. Sources of growth in Chile: 1984-89
Consumdtion Investment _Ex wrts inorts GDP
rate of share rate of share rate of share rate of share Groth
growth of GDP growth of GDP growth of GDP growth of GDP
(Z) (M) (S) (Z) (2) (X) (2) (X) (Z)
1984 1.3 87.4 75.4 13.6 6.8 24.3 16.5 25.3 6.3
1985 -1.0 83.5 -6.7 13.7 6.9 29.1 -11.1 26.3 2.4
1986 3.8 81.6 14.3 14.6 9.8 30.6 9.6 26.8 5.7
1987 3.8 79.0 25.8 16.9 8.8 33.5 17.1 29.4 7.7
1988 9.0 75.8 8.5 17.0 6.1 37.4 12.1 30.2 7.4
198Y' 8.1 77.0 32.6 22.0 14.8 29.0 26.3 28.0 10.0
Source: The World Bank
- estimate
9
producing for external markets - a factor captured mainly by non-copper
exports. Thn increase in the basic tariff rate' from 10 percent to 20
percent (whose anti-export bias was more than offset by the real depreciation)
and indirest tax reimbuisement for export@ have also contr,.buted to the
expansion of the tradab,.a goods sector in general. In addition, the existence
of idle capacity (until 1987) and the ample availability of labor also
contributed to the expaniton of export and import competing activities.
Besides the positive impact of supportive macroeconomic policies and a
competitive real exchange rate on the very rapid expansion of non-traditional
exports in Chile (fresh fruit, fish, paper. timber) this process is also
related to institutional factors and structural change carried out in the
sixtics and seventies. The CORFO (Croporaci6n de Fomento de la Producci6i.,
plan of fruit growing (1968) and the afforestation activities of 1966-73 wera
two initiatives that boosted agricultural development and also the ability to
export in these arrRas. The agrarian reform of 1965-73 also contributed, in
spite of transitional problems, to help modernize the agricultural sector from
the latifundior (quasi-feudal) str cture. MoreovBr, after 1974 a new process
of land redistribution, sale b- tender and auctioning -- starting from the
structure left after the agrarian reform process -- took place. giving rise to
a more aczive land market that was needed to support a more oowpetitive
environment in agriculture.'
Total investment has been stimulated by various factors5. Besides the
recovery of public investment, the reduction in real interest rates
undoubtedly contributed to the recovery of private investment. A monetary
policy of real interest rate targets, conducted in the context of a financial
market characterized by the extensive use of indexed financial instruments.
' Specific import duties were imposed on some products where evJ.dence of
dumping was found.
' See ECLA (1990) for a further discussion of these issues for the case of
Chile.
s An econometric analysis of the behavior of private investment in Chile
during the eighties is carried out in Solimano (1989).
10
was the chief mechanism behind the interest rate policy.6 Tax incentives
seem to have played also an important role in the recovery of private
investment in Chile, as the tax rate on corporate incomes was reduced from 46
percent to 10 percent; in addition, reinvested profits received a preferential
tax treatment over dividends.
The average rate of growth of GDP in the Chilean economy was 8.7
percent during 1988-89 (10 percent in 1989). That ixceedingly high growth
record seems to reflect, to a considerable extent, two elements: the first is
related to an improvement in external conditions in the form of high copper
prices (a positive terms of trade shock) observed since 1987, and the second
is a political business-cycle feature, namely the adoption of a highly
expansionary monetary policy in the second half of 1988 -- Ml grew nearly 50
percent in that period -- as a plebiscite over the permanence of the military
regime was to take place in October of that year. In addition, given the
traditional lags in the effects of monetary policy on real economic activity,
the stlmulative effects of the late 1988 monetary expansion were largely felt
also in 1989. Moreover, the presidential and parliamentary election of
December 1969 was preceded by a rather lax monetary stance that rapidly
resulted in an acceleration of inflation in the last quarter of 1989.
Therefore an attempt to maintain a pace of growth thai. reflects, to a large
extent, cyclical elements, over a more extended period of time. would sooner
or later conflict with other targets of macroeconomic policy like muintaining
low inflation and the preservation of external balance. In that perspective,
since December 1989 the central bank is tightening monetary policy in order to
cool down growth. The actual deceleration in growth during 1990 has been
sharp and the forecasts for 1990 predict a rate of GDP growth of around 1-22
for the year (down from 102 in 1989).
6 According to Fontaine (1988). the level of the real interest rate was
determined on the basis of two criteria: to provide a reel return to domestic
financial assets competitive with the return of financial instruments abroad, so
to avoid capital flight and, second, the real interest rate should be consistent
with a real cost of credit that does not hamper the recovery of investment.
11
2.3.2 Whv the adjustment of relative prices and the financial crisis was
non-inflationary in Chile?
An interesting issue mentioned before is the non-inflationary adjustment
of the Chilean economy, in spite of a large real depreciation of the exchange
rate -nearly 45 percent since 1984 (see table 1) -- and the turnaround of a
serious financial crisis that required massive Central Bank intervention.
Two explanations may be advanced in this regard.r First, the series of
devaluations starting in 1982 were accompanied by de-indexatio., of wages; thus
a real depreciation did not require a permanent acceleration in inflation in
order to reduce real wages. In addition, the increase in the rate of
unemployment, reaching levels over 20 percent in 1982-83 and remaining fairly
high until 1987, acted as a "labor market-deterrent" for workers attempting to
recover the level of real wages squeezed after the crisis of 1982. With ample
slack in the labor market. firms were not forced to bid up for additional
labor through higher wages (mainly for less skilled labor, where unemployment
concentrated) a factor that prevented an acceleration of inflation coming from
the wage side during the adjustment process. Clearly in Chile the "classical"
price-wage-exchange rate spiral resulting from an attempt to modify the reil
exchange rate while maintaining wage indexation and monetary accommodation
was absent. However the "Chilean way" was not costless in terms of economic
activity and real wages, though the costs were tilted towards the first phase
of the adjustment process.
A second factor refers to the fiscal situation. In Chile. like in
other highly indebted countries, the strain on the public sector accounts
resulting from the crises of 1982-83 centered mainly (but not only) on the
quasi-fiscal deficit (central bank budget). The deterioration stemmed both
from the increase in the domestic currency value of servicing the external
debt after 1982. and of the reecue program of troubled financial institutions
and conglomerates set-up by the Central Bank. These adverse quasi-fiscal
shocks have been non inflationary for two main reasons: first the non-
7 Sea Corbo and Solimano (1990) for an econometric analysis of inflation and
stabilization in Chile during the last two decades.
12
financial public sector in Chile ran a surplus In its primary deficit during
this period. transferring part of it to the central bank to cover its new
losses. Second, the rescue operations of troubled financial institutions were
carried out by issuing interest bearing liabilities of the central bank
rather than by issuing high powered money. The issuing of interest-bearing
liabilities by the Central lank was directed to finance debt-relief schemes
for borrowers of the banking system, to the purchase of risky loans by the
Central Bank with a (generous) repurchase obligation on the part oi banks'
shareholders and to the recapitalization and subsequent sale (financed with
government credit and subsidies) of intervened banks to small investors (the
"capitalismo popular" scheme)'. It is notevorthy to recognize that the whole
scheme of reshuffling the banking system involvod placing large amounts of
central bank bonds in the market. That required, of course, a corresponding
increase in demand for such assets. The rapid recovery of the Chilean economy
since 1984 in terms of growth of output, certainly was instrumental in that
regard (also because it helped increase private savings). In a medium-term
perspective, however, these new Central Bank interest-bearing liabilities
constitute a "latent inflationary pressure" that can be triggered if other
"non-monetary" sources of central bank revenues deteriorate in the future.
2.3.3 Incidence of the costs of adiustment and the benefits of recovery
and growth
A key and difficult question is the social distribution of the costs and
benefits of the macroeconomic adjustment. Table 2 shows that average real
wages recovered their 1980s level just in 1988 and that minimum wages in real
terms were still 20 percentage points below their 1980 level and 35 points
under their 1982 level. That suggests that labor, and particularly low wage
groups, paid a significant share of the costs of adjustment in Chile. In
turn, the benefits for labor of the recovery after 1984 have taken more the
form of an employment increase rather than real wage growth. The step from
' See Larrain (1989) for a detailed account of the management of the Chilean
financial crises.
13
functional to personal income distribution is hard to make, particularly in
the case of Chile because of the absence of comprehensive information on
income distribution in this period. However, actions like the cut in some
items of social spending e.g., pension payments, and the squeeze on public
sector wages suggest that middle-low income groups also suffered in the
adjustment process. The incidence of the costs of adjustment on high income
groups is less clear since their income tax rates were reduced. Asset
transfers in the privatizations that took place after 1985 and the granting of
subsidies to the financial sector provide some clues that high-income groups
were shielded, in part, from the costs of adjustment.
3. The Analytical Model
In this section we set up a simple aggregate model for the Chilean
economy. We basically use an open economy IS-LM framework, extended to
incorporate the supply side and the labor market. We consider one single
domestic good' that can be used for consumption, investment, and exports, and
whose market must clear at every instant; goods market equilibrium determines
the real exchange rate and real output. In contrast. the labor market need not
clear in the short run due to wage rigidity.
The presentation of the model will start with the components of
aggregate demand and aggregate supply for domestic goods. Then we will turn
to the labor and assets markets, and provide a simplified representation of
the behavioral model. We close the discussion with the budget constraints of
the economic actors.
The Goods Market
Let us turn first to the demand side of the goods market. Aggregate
demand for domestic goods is the sum of public and private consumption and
' This may seem odd in view of the important role of copper in the Chilean
economy. The model assumes that copper is produced only for exports, and that the
production volume is exogenous. Sowever, copper revenues will be endogenously
daterained by prices and exchange rates (see below).
14
investment. plus net exports.
The private consumption equation is based on the assumption that there
are two groups of consumers: the first group is liquidity constrained (they
cannot borrow in capital markets against their future income), so that their
consumption depends on current real disnosable income'0, Yd. The other
consumers (e.g. the wealthy, and upper-middle income groups) are
unconstrained, and determine their consumption according to the life cycle-
permanent income hypothesis (Hall, 1978); thus., their current consumption
depends on past consumption and on the unanticipated change to permanent
income, which can be summarized also by current disposable income. Aggregate
consumption Cp, is the sum of consumption of the constrained and unconstrained
consumers; hence it depends on both current income and lagged consumption:"
(1) Cp. - Cp,(Yd, CP.-J
Real disposable income is defined as:
(2) Yd - [pY - T - e*FFP]/pe
where Y is real output, p is the domestic price level, T are taxes, e is the
nominal exchange rate (units of domestic currency per unit of foreign
exchange), p, is the consumption ieflator, and FFP is net factor payments
abroad (in foreign zurrency terms). which are given by profit remittances PR
plus interest payments on net foreign debt:
(3) FFP - PR + i^-(FD-RE)
with PD and RE denoting foreign debt and foreign reserves, respectively.
10 For recent evidence that the role of liquidity constraints in consumption
is more important in countries with relatively less developed capital markets (as
most LDCs), see Jappelli and Pagano (1990).
11 We have omitted, just for simplicity, two possible extensions: first,
the distribution of income between wage earners and profit recipients could be
another determinant of consumption spending (Diaz-Alejandro, 1965). Second, the
ex-ante real interest rate could also affect private consumption -- although the
direction of this effect is theoretically (and empirically) ambiguous. In our
empirical work we could not identify either of these two effects.
15
Private fixed investment is determined along the lines of the standard
cost-of-adjustment model (Hayashi. 1982). Thus, investment depends on Tobin's
Q, the ratio of the market value of installed capital to its replacement cost.
However, because of market imperfections, firms may find themselves rationed
in financial and/or goods marketsg hence, we must also allow for a direct
effect of current profits and demand conditions'2 on investment. Demaad
conditions are measured by the degree of capacity utilization in the economy
Y/Yp, where Yp denotes potential or full-capacity output. In turn, with
variable production inputs (labor and materials) optimally adjusted, current
profits can be shown to depend only on the degree of capacity utilization. In
summary, private investment can be expresSedQd
(4) Ipr - Ip, (Q. Y/Yp)
In turn, Tobin's Q depends on anticipated profits and the real interest
rate", r. As before, profits are summarized by the degree of capacity
utilization, Y/Yp:
(5) Q = q(r, Y/Yp)
Government consumption, C6, and public investment, I., are considered
policy determined variables so they are exogenously given.
Real copper exports X.w are exogenous; in turn, non-copper exports X;
are endogenously determined. They depend on the price of competing foreign
goods relative to the price of the domestic good ep*/p, and on the level of
12 For a formal proof that when the firm faces sales constraints the optimal
investment rule depends on both Tobin's Q and goods demand, see Precious (1985).
"3 For notational simplicity, all behavioral equations are written as
static. However, in their empirical implementation we will allow for dynamic
effects.
" More precisely, Tobin's Q can be shown to equal the present value of
future unit profits, discounted at the real rate of interest plus the
depreciation rate of capital, (r+5). Under static expectations, this equals
current profits divided by r+S. In turn, with profits described by the degree of
capacity utilization (as argued above). Tobin's Q can be expressed as in (5).
16
world demand Y:
(6) X. X (Sp,/P. Y')
Real imports depend on the tariff-inclusive relative price of
importables in terms of domestic goods, ep (l+t)/p. where p' is the world
price of importable., and on the level of output Y:
(7) M - m(ep.(l+t)/p. Y)
Equating output to aggregate demand, we have:
(8) Y m Cpr + C6 + Ipr + Is + Astk + X¢o + X - M
where Astk denotes inventory investment, which is exogenously determined.
On the supply side, we assume that output is produced according to a
constant returns to scale technology that uses labor, capital and imported
materials. Assuming profit maximization, we can write the supply function as
(9) Y/Yp - ye(w/p, ep*./p. p)
where w is the nominal wage rate, p'3 is the foreign-currency price of
imported materials", and p is a productivity parameter. Solving for p. we
can write the inverse supply function as
(9') p - p(w. ep"*, p. Y/Yp)
which expresses the price of domestic goods p as a (variable) markup over unit
variable costs, with the markup rate increasing with the degree of capacity
utilization Y/Yp". Moreover, equation (9') must be homogeneous of degree one
in input prices.
Finally, the change in the level of capacity output is related to the
I Here we are assuming, only for notational simplicity, that the world
price of foreign materials in terms other importables is constant.
14 Notice that in principle this markup specification would be consistent
with either perfect or impertect competition in the goods market.
17
path of the capital stock:
(10) &Yp/Yp - AK/K
and the capital stock changes over time according to net investment:'7
(11) AK - (Ip,+Is) - 6K
The Labor Market
Because of wage stickiness, the labor market need not clear in the short
run. Labor supply equals the labor force L; actual employment is always
determined by labor demand. The specification of the latter follows from
profit maximization; hence, labor demand is related to the real wage w/p and
the level of output Y:
(12) L - 1( w/p. Y)
The rate of unemployment is defined as
(13) u = 1 - L/L
The labor market is completed with an equation describing the rate of
change of the average nominal wage w. The latter depends on four factors.
First, the rate of change of the consumer price index Apj/p0, reflecting
inflationary expectations and/or the existence of wage indexation. Second, the
rate of change of the minimum wage Awmin/vmin, which affects the average wage
directly through a "composition effect" (since a fraction of the workers earns
the minimum wage) and also through an indirect "relative wage" effect, which
links the whole structure of wages to the minimum wage. Third, the degree of
slack or excess supply in the labor market measured by the rate of
unemployment u, along the lines of a Phillips curve specification. Finally,
wage growth depends also on labor productivity g,,. Formally.
17 Here we are making the simplifying assumption that public and private
investment are equally 'efficient' in increasing productive capacity.
18
(14) Aw/w - v(Ap./p, Awmin/wmin, u, )
The Money Market
We use a very simplified representation of assets markets. There are
three assets in the economy: money, domestic interest-bearing assets o, and a
foreign bond; the latter two assets are imperfect substitutes. Moreover, we
assume that there are barriers to capital mobility; hence, the private sector
cannot adjust instantaneously its holdings of foreign assets"'. In addition,
we assume that the nominal exchange rate is fixed (or managed by the
authorities).
We can su-arize portfolio equilibrium by considering the money market.
Formally, real money demand h depends on the nominal interest rate i, the
level of output Y, and the foreipn interest rate, i-. adjusted by the expected
rate of devaluation of the exchange rate, Alne. Hence money demand is
(15) h - h(i, Y, is + Alne')
Letting H denote the nominal money stock, money market equilibrium implies
(16) H/P = h(i, Y, iC + Alne)
or, solving for the domestic nominal interest rate,
(16') i i( H/p, Y, i + Alne')
In turn, the domestic real interest rate r is equal to the difference
between the nominal interest rate i and the anticipated inflation rate We:
17) r - i - w
IS The domestic asset implicitly includes public debt and the claims on the
capital stock -- i.e., holdings of equity. This amounts to assuming that domestic
debt and equity are perfect substitutes (up to a constant risk premium).
19 This assumption ensures that at every instant the money stock is
predetermined; however, we could eliminate it without any analytical
complication. Also, we could allow explicitly for a parallel foreign exchange
market without major difficulties (other than empirical).
19
Price Defipitions
The model is completed with two equations describing the consumption and
investment deflators. Both consumption and investment are assumed a composite
of domestic goods and imports. Hence their implicit deflators can be expressed
(18) P a Pc(P. eep' (1+t))
(19) Pk P Pk(P' e9p*.(1+t))
where Pk iS the investment deflatorl further, both p, and pk must be
homogeneous of degree one in p and eop (l+t).
Finally, the national accounts nominal income-expenditure identity can
be written
(20) pY - p,e(Cpr+Cg) + pK*(Ip,+It) + p,st,Astk + e*(p*4OeXCOP+p*X.-p%M)
where p*0op is the world price of copper, which is exogenously given; equation
(20) is used to determine the deflator of inventory investment P.tk*
A SimRle GraDhical Regresentation of the Model
We can provide a simple graphical representation of the model by
reducing it to three equations depicting aggregate supply, aggregate demand,
and the current account balance, all in terms of the real exchange rate, real
output, and for given values of the remaining variables. First, a semi- p ;
reduced form for aggregate demand AD can be obtained by replacing equations
(1) through (7), (16'), and (17) through (19), into (8):
(21) AD - AD(ep-/p, H/ep-, a4)
where ad * (Cs, IB, TD, t, (FD-RE]/p*, PR/p', Y, i*, Alne*, p*/p**, X0op, P*Op/p*,
ir, Cp-1), and in arriving at (21) we have used the fact that H/p
(H/ (ep*)) (ep*/p).
Letting e1 * ep*/p denote the real exchange rate, and for given ad and
20
given real money stock in terms of foreign goods H/(ep*)20, the AD schedule is
depicted in Figure 1 as an upward sloping l ne in the real exchange rate-real
output space (et. Y), reflecting the assumption that a real depreciation of
the exchange rate raises aggregate demand -- that is, the positive effect of a
real depreciation on net exports dominates its negative effect on real
disposable income and consumption. which is due to the increase in the value
in terms of domestic goods of foreign debt servicing payments, and in the
decrease in the value in terms of consumption goods of a given disposable
income in terms of domestic goods21.
The position of the AD schedule is determined by the values of the real
money stock H/(ep') and the other variables included in ad (i.e., all the
variables other than e3 that affect aggregate demand) 22
In turn, the aggregate supply schedule AS is just given by (9).
rewritten here as
(22) AS = AS(ep*/p, w/(ep-), a.)
where a, a {(, Yp, p'3/p'), and we have used the fact that w/p
(ep'/p)(w/(ep')). Thus, for givo.r a. and given real wage in terms of foreign
goods, the aggregate supply schedule is downward sloping in Figure 1,
reflecting the fact that a real depreciation increases the relative price of
imported materials (as well as the product wage w/p for given w/(ep*)) c.ad
20 Here we are making the important assumption that anticipated inflation
and depreciation are predetermined.
21 In Solimano (1986) a macro model of a devaluation is set up and
parameterized with Chilean data. The main result ie that a real depreciation
turns out to be contractionary in the short run followed by an expansion in
output and employment in the medium to long run. A real depreciation may affect
adversely absorption also via a cut in investment due to higher cost of imported
capital or because of a reduced access to credit by firms overindebted in
dollars. See Serven and Solimano (1990' for a full review of the effects of a
real depreciation on investment.
22 Note also that the inclusion of lagged consumption in ad gives rise to
a distinction between short run and long run equilibrium. The short run AD
schedule will be shifting over time as the economy approaches a stationary
equilibrium. In our empirical model this is more so, as other lagged endogenous
variables (e.g., exports or the real exchange rate) would also be included among
the determinants of aggregate demand.
21
thus reduces output supply. A step beyond would be to insert the laws of
motion of the nominal wage and the capital stock (equations (11) through (14))
in (22). bringing out the dynamics of aggregate supply -- and allowing for a
distinction between the short run and long run aggregate supply schedules.
Finally, the current account deficit measured in terms of domestic goods
CA is given by
(23) CA - (e/p) i* (FD-RE) + PR - FTR + p.OM - p.p&- pPX,¢]
where FTR are net foreign transfers; the term (e/p)@(p M - p40cX00p - p*XJR is
the resource deficit. Inserting equations (6) and (7) in (23) we get:
(24) CA = CA(Y, ep'/p, iL, (FD-RE]/p*, FTR/p-. X,., YV. P-*/P*. P*-/P*)
= CA(Y, ep*/p. a..)
Setting the right-hand side of (24) equal to zero, we obtain the CA
locus in Figure 1. which represents the combinations of output and the real
exchange rate that yield a balanced current account for given values of all
the other variables. The locus slopes upward, due to the fact that an
expansion in output raises imports and hence the resource deficit, and must be
compensated with a real depreciation in order to maintain the current account
in equilibrium. Points above the CA locus correspond to current account
surplus; points below correspond to current account deficit.
The domestic goods market clears when aggregate supply and demand are
equal; in Figure 1, this happens at point E. In the figure we have assumed
that E also corresponds to a balanced current account; hence, at E the economy
is in full macro equilibrium: the levels of the real exchange rate and output
are consistent with both internal balance2" (aggregate demand = aggregate
supply) and external balance (equilibrium in the current account).
Of course, the meaning of "internal and external balance" in our
2 A related issue is that of the stability of internal equilibrium. A
sufficient condition for static stability is that the aggregate demand schedule
be upward sloping, as assumed here. The dynamic stability under rational
expectations of a model similar (but somewhat simpler) to ours is examined in
Serven (1991).
22
framework must be qualified: on the one hand, internal balance may occur with
unemployment in the short run. On the other hand, external balance may be
consistent with a sustainable deficit in the current account, and not
necessarily with a zero deficit.
Tne functioning of the model can be seen by performing a simple
comparative static exercise, such as an increase in public spending that
shifts down and to the right the aggregate demand schedule in Fig,-re l(a)
(dotted line). The new short term equilibri m would be at E' where the real
exchange rate appreciates and the level of output increases (assuming output
is below full capacity). At E', however, there is now a deficit in the
current account which has to be financed either through an increase in
external borrowing and/or running down international reserves.
Another exercise of interest is a devaluation (i.e., an increase in e).
Of course, if a nominal devaluation is to have an impact on real variables, it
must not be accommodated by proportionate increases in nominal wages and the
nominal money stock; otherwise, as is clear from (21) and (22), real variables
would be completely unaffected, while p. v and H would all rise in the same
proportion as the nominal exchange rate.
In Figure l(b), we depict the effects of a devaluation holding constant
the nominal money stock and the nominal wage. From (21) and (22) it is clear
that both the real money stock and the real wage in terms of foreign goods
must fall, and thus the AS and AD schedules shift upwards; the CA schedule is
unaffected. Hence the outcome is a real depreciation and a current account
surplus; however, the effect on real output is in principle uncertain,
although if the adverse impact on interest rates and hence on investment
demand is not too large, output should be expected to rise, as represented in
E' in the figure.
Let us consider the determination of the rate of inflation by looking at
the dynamics of aggregate demand and aggregate supply. This is useful for
addressing ptoblems of inflation stabilization and to examine the inflationary
effects of wage indexation and exchange rate rules and money growth, and in
23
particular the issue of inflati.L inertia.
We can .1lvstrate these iss:iis as follows. First, equating aggregate
demand with aggregate supply.
AD( ep*/p, H/(ep*) 9 ad) - AS( ep'/p. w/(ep*), a,)
and solving for the rate of change of the price level n, we have
(25) - - a (Aw/w) + b (Ae/e) + c (QH/H) + v
where a+b+c.1, v is a function of the rates of change of a, and ad, and
foreign prices have been assumed constant. For given v, the rate of inflation
is a weighted average of the rate of wage inflation, the rate of devaluation
and the rate of cnange in the money supply; in turn, inflation may rise or
fall due to the effects of supply and demand shocks (the v term).
We can use (25) to illustrate the effects of the wage formation process
and exchange rate rules on inflation. Assuming a linear functional form for
the rate of change in nominal wages we can write equation (14) as:
(26) Aw/w - (1-9)OWC + Bs(Awmin/wmin) - 7*u 0 c a c l
where ¢r is the rate of change of the consumption deflator; y>OS and for
simplicity we have ignored productivity growth. Hence the rate of change in
average nominal wages is a function of consumer inflation. the rate of change
in minimum wages, and the rate of unemployment. Let us assume that the minimum
wage is indexed to current and past inflations
(27) Awmin/wmin - (1-9)rw + Ow,,_1 + k 0 < a 1
where k is an exogenous minimum wage shock. Replacing (27) in (26). we can
write
(26') Aw/w - Sk= 3k- 59(ir0 - 7c..y) u
which implies that, given k, the real consumption wage can only be reduced by
accelerating inflation (as long as 8>O) or through unemployment. On the other
hand, from (18) we can write w, - Ax + (1-A)(Ae/e), where OAcl is the share
24
of domestic goods in the consumption basket. Finally. let us assume that money
growth and nominal depreciation partially accomiodate inflation; hence Ae/e -
,. and AH/H ft where O04,0cI. With all these ingredients, we can rewrite
(25) as
(28) w ' - - 'u + vI
where a * D-'a890A+(1-A)9], 7'U D-'7, v'u D-l(v+k), and D a 1-bq-c'y-a(l-
89)(A+(1-A),X]>0. Equation (28) shows that inflation depends on three factors:
lagged inflation, unemployment, and exogenous supply, demand, and minimum wage
shocks. In particular, the degree of inflation inertia is measured by a.
Hence, as can be directly verified, the larger the weight of minimum wages in
average wages E. the larger their backward indexation 9, and the more
accommodating money and exchange rates are (i.e.. the larger 0 and q). the
more persistent inflation is. In particular, with full accommodation (.-4=1),
(28) reduces to
(28') - - w - (a&90)Y^u + (aBO)-'(v+Bk)
so that current inflation fully reflects past inflation, irrespective of the
degree of backward indexation 9; however, the larger 0, the more costly in
terms of unemployment it is to reduce inflation below its past level.
Budget Constraings
The behavioral model is completed with the budgetary identities of the
different economic actors - that is. the private, public, and external
sector. These ensure the consistency between stocks and flows in the model.
which is necessary for the simulations to be of any practical interest.
One important issue is the appropriate degree of disaggregation of the
public sector. Normally, for the purposes of macroeconomic analysis, it would
suffice to consider the consolidated financial and nonfinancial public sector
-- that is, including the Central Bank. However, in the Chilean case the
recently introduced autonomy of the Central Bank creates some unusual fiscal
25
problems, due to the large stock of Central Bank debt to the private sector,
and to an equally large stock of foreign-currency denominated liabilities of
the Government with the Central Bank. In order to keep close track of the
fiscal implications of these two issues, we choose to consider these two
agents separately.
To adapt the budget identities to the Chilean institutional context, we
must take into account two facts. First, most domestic currency financial
instruments (with the obvious exception of the money stock) are indexed to the
price level. The interest actually paid on such instruments is given by a
market determined 'real' interest rate applied to the actualized (i.e.,
according to inflation) principal of the instrument.
Second, the way in which the nonfinancial public sector (more precisely,
the central government) services its main liability with the Central Bank
(which has the form of a dollar-denominated Treasury note held by the latter)
is somewhat special. The liability originates from the consolidation of past
transfers to cover the Central Bank's operating losses. Interest on the
Treasury note accrues at a rate equal to LIBOR plus a fixed spread. However,
the actual interest payment by the government is only 2 percent of the
principal; the remaining interest accrued is capitalized. Moreover, the
government can also make anticipated amortization payments to reduce the
principal of the note".
Keeping these issues in mind, we can now describe the budget constraints
of the model. First, the identity of the external sector is just the Balance
of Payments, which in terms of foreign currency can be written
(29) P *°M - (P*07, + P',peX,Op) - FTR + (PR + i**(FD-REj) - DPI + A[FD-RE]
Here DFI is direct foreign investment; all variables (with the exception
of real imports M and real copper and non-copper exports XCOp and X.,) are
measured in foreign currency (dollar) terms. The left-hand side of the
24 For example, in 1990 the government made an amortization payment of US
$ 230 million.
26
equation is the current account deficit described before; the right-hand side
is the capital account balance. Again, the term in square brackets FD-RE
represents pet foreign debt.
In turn, the budget constraint (in nominal terms) of the nonfinancial
public sector can be written
(30) (p,*Cg + GTR1b + OE + ropO[b. + dc,]+ eoiO1FD, - CSF?)
- (TD + TI + OR + CUR) + pk*I8
n p@(Adc, + abs) + e*AFDg - eo(TBAmort + ACSF)
The first two lines of (30) represent the public deficit. The first term in
brackets represents current expenditures; the second, current revenues. Here
TD and TI respectively denote direct and indirect tax revenue in nominal
terms; CUR represents nominal revenue from copper production (i.e., the pre-
tax operating surplus of the public copper company); OR and OE are other
current revenues and expenditures2", expressed in nominal terms; CSF is the
'Copper Stabilization Fund', which we describe below; and GTR0b is a transfer
to the Central Bank. also expressed in nominal terms, which corresponds to the
interest paid on the Treasury note held by the Bank. Letting TB denote the
principal of the note (in dollars), GTRCb is determined according to
(31) GTRCb - oOe*TB
where a is a given parameter (currently equal to 2 percent, aS explained
above). In turn, copper revenues are related to copper prices and exchange
rates by the following equation:
(32) CUR = (eSP*,, - 9P)OYS"
where a is a cost parameter, and Yd,. denotes the volume of public copper
production. Thus, nominal production costs are assumed to rise one for one
25 OR includes basically nontax revenues of the government and the operating
*urplus of public enterprises other than the copper company. In turn, OG mainly
involves transfers and subsidies to the private sector.
27
with domestic prices.3'
The bottom.line of the public sector's budget constraint reflects the
change in the net liabilities of the nonfinancial public sector. Here dc, and
ba are the net domestic credit from the Central Bank2" and net public debt
held by the private sector, respectively, and they are defined in real terms;
hence, the corresponding interest payment is determined by the real interest
rate times the adiusted value of the principal, where the latter is determined
by the price level. In turn, PD. is net foreign debt of the nonfinancial
public sector.
The last two items in the right-hand side of (30) are somewhat unusual
and deserve separate comment. First, TBAmort represents the amortization
payment made by the government on the foreign currency-denominated Treasury
note held by the Central Bank2; its amount is arbitrarily determined by the
government. The principal TB evolves over time according to
(33) ATB I=*TB - (GTRcb/e) - TBAmort
so that if no amortization is paid, then the change in the principal plus the
current transfer received by the Central Bank add up exactly to i'*TB, i.e.,
the (spread-inclusive) world interest rate2" times the principal of the
Treasury note.
In turn, CSF is the 'Copper Stabilization Fund', expressed in
dollars'°. It represents a government account at the Central Bank to which a
fraction of copper revenues is deposited whenever the copper price exceeds a
26 Actually, part of the operating costs of CODELCO correspond to cop er
purchases and thus are related to copper prices. For simplicity, we ignore this
in (32).
2' According to the new regulations in Chile, the Central Bank is forbidden
from lending to finance public deficits. Hence, Ado, cannot be positive.
26 Notice that such note is not included in dc.
29 As described above, i would equal LIBOR plus a fixed spread.
3O Again, the copper fund is not included in net credit from the Central
Bank dc.
28
specified upper bound, and from which withdrawals can be made when the price
falls below a likewise specified lower bound. In summary. we can write:
(34) ACSF - p y
-here 0<1 (and not necessarily positive), and its precise value depends on the
world price of copper relative to the specified upper and lower bounds31.
Finally, we have the Central Bank's budget identity:
(35) e9i^6(FD.b-RE) - rep*(dc5 + dcp,) - GTRCb + eoi*CSF -
ISB + e*A(FD¢b-RE) - pA(dc8+dcpj) + e*(TBAmort+ACSF)
The top line of the equation is the operating loss of the Central Bank,
with dcpr denoting real net credit to the private sector32; thus, the loss
equals the interest paid on net foreign liabilities minus the interest
received on net domestic assets (excluding the Treasury note), minus the
transfer from the government, plus the interest paid to the latter on the
Copper Fund.
The bottom line again denotes the change in the net liabilities of the
Central Bank which finances its net operating loss. It comprises the increase
in the money base HB, and in net foreign indebtedness, the decline in net
domestic assets, and the payments received from the governmeut for deposit to
the Copper Fund and for amortization of the Treasury note3
In the model, the monetary base is related to the money stock H by the
money multiplier p, which is assumed exogenous:
(36) H * IASHB
" Alternatively, we could have defined de, as net of the copper fund CSF and
of the Treasury note TB. The approach used in the text intends to highlight the
important role of these two items in the Central Bank-Central Government link.
1 Net, in particular, of domestic debt of the Central Bank held by the
private sector. hus, in the Chilean case dep, is negative.
33 Obviously, if the operating lose is zero and if there are no government
payments to the Copper Fund or for amortization of the Treasury note, the
equation collapses into the standard money supply identity.
29
To conclude the presentation of the budget identities"'. it may be
instructive to consider briefly the budget constraint of the consolidated
public sector, including the Central Bank. Suminig (30), and (35), this can be
written
(36) p¢*C. + OE + r*polb, - dc,lJ + eei**[FDS + PDb - RE]
- (TD + TI + OR + CUR) + pkeI8
m poMbs - dcp,l + e@A(FD, + FDb - RE) + AHB
where (FD,+FDCb-RE) and p*(b.-dcp,) respectively are the net foreign and
domestic debt of the overall public sector. Using the money market equilibrium
condition (16) along with (33). and after some well known manipulations, we
can rewrite (36) in compact form as
(36') def + rob + tr* + (Ae,/el)]f = Ab + bf + (1/p)*(Ah(.) + *h()]
where def a (poC$ + OE - (TD + TI + OR + CUR) + pk-l, I/p is the primary
deficit of the overall public sector in real termas b a b.7dcpr is the real
domestic debt stock; f E (e/p)*(FDi+FD.b-RE) is the real value of the net
external debt stock of the public sector in terms of domestic goods; r a i*-f*
is the foreign real interest rate; et denotes the real exchange rate, as
before; and h(.) is the money demand function (15).
The left-hand side of (36') is the inflation-adjusted deficit of the
overall public sector, which includes the real primary deficit plus real
interest payments on domestic and foreign debt; observe that the real interest
rate relevant for foreign debt is the world real iinterest rate plus the rate
of depreciation of the real exchange rate' Aede1. The adjusted deficit must
" In principle, the model would also include a budget constraint for the
private sector. However, such equation can be shown to be a linear combination
of the budget constraints of the other sectors and the National Accounts income-
expenditure identity (20), and thus it need not be considered explicitly.
35 Obviously, with unrestricted access to foreign and domestic financial
markets, the optimal financial strategy of the public sector would be to
diversify its sourc i of financing only if r - r'.&ee1S. This has been emphasized
by Buiter (1989).
30
be financed by increasing the real stocks of foreign and/or domestic debt, or
by seigniorage revenues (the last term on the right-hand side).
In order to ensure that public debt will not eventually grow without
bound, we must require that real interest payments on the debt stock be met by
future primary surpluses and seigniorage revenues (where the latter include
the increase in real balances plus the inflation tax revenue)36. In terms of
the model, this can be done by imposing simple fiscal (or quasi-fiscal) policy
rules, such as assuming that increases in debt service are matched in every
Period by tax increases (as in, e.g., McKibbin and Sachs (1990)). While this
can be easily done, it would unnecessarily limit the ability of the model to
explore some quite realistic scenarios of 'sustained' fiscal imbalance. A more
flexible approach is to allow for arbitrary fiscal imbalances in the short to
medium term, while imposing fiscal adjustment in the longer term.
4. Empirical Results
4.1 Preliminary Issues
The structural model summarized in the previous section consists of
eleven estimable equations: four for the components of aggregate demand
(private consumption, private investment, imports, and non-copper exports),
three goods prices relationships (the inverse supply schedule, and the
consumption and investment deflators), two labor market equations (for
employment and nominal wages), and two asset markets relationships (for
Tobin's q and the domestic interest rate).
36 Formally, integrating (35") under the assumption that debt does not
explode in the ong run, we can write the intertemporai budget constraint of the
public sector as
b(t) + f(t)
Go
f exp{-R(s))@((^h(s)+ir(s)*h(s))/~ - def(s)] ds + f exp(R(s)-R*(s)}*f(s) ds
t t
s 5
where R(s) a I r(v) dv, R (s) a I (r(v)+Ase(v)/et(v)] dv. That is, the existing
t t
debt stock must equal the present discounted value of future primary surpluses
plus ssigniorage revenues, plus an additional term that adjusts for the
discrepancy between domestic and foreign (real depreciation-adjusted) real
interest rates.
31
As written above, the behavioral equations (with the only exception of
that for private.consumption) contain no dynamics. However, in reality we must
allow for the slow adjustment of the left-hand side variables to their
'target' levels. For example, decision and delivery lags in the case of
investment, or slow market penetration in the case of exports, can account for
substantial differences between the short- and long-run responses of
investment or exports to their determinants. Thus, in our empirical equations
we included lags of the dependent and/or independent variables to capture this
lagged adjustment effects. In most cases, a standard cost-of-adjustment model
proved sufficient.
In principle, efficient estimates of the model's parameters could be
obtained from a joint estimation technique (e.g., three-stage least squares or
full information maximum likelihood). However, the available sample (which
includes fewer than 30 data points) is 'undersized', as the sample size falls
short of the total number of predetermined variables in the model. In such
context, the maximum likelihood estimator is not well defined (Sargan (1975)),
nor is the 3SLS estimator (as the instrument matrix fails to have full column
rank). Alternative system estimators based on instrumental variables have
been proposed in the literature (see e.g., Swamy (1980)); each one of them
results from a particular set of restrictions on the set of instruments
employed in the estimation, and therefore can be interpreted as imposing
implicit (and arbitrary) restrictions on the model's reduced form parameters
(for a discussion, again see Swamy (1980)). However, the relative advantages
of the alternative estimators are not entirely clear, as the comparisons of
performance often rely on asymptotic arguments which by definition are of
little interest in the context of small samples. Finally, the computation of
some of the system estimators for undersized samples can be rather cumbersome
(e.g., Brundy and Jorgenson (1971)).
On the other hand, joint estimation techniques pose the well-known
problem that misspecification of any equation will 'contaminate' the rest of
the model, leading to inconsistent estimates in all the equations.
32
In view of these facts, we decided to estimate the model using 2SLS
equation by equation, with different sets of instruments for each equation".
In this manner, we avoid the problem of contamination - at the cost of some
possible losses in efficiency, which in an undersized sample such as ours are
not likely to be of great significance.
4.2 Estimation Results
The equations of the model were empirically estimated using annual data
for the years 1960-1987. Overall, the estimated equations provide reasonably
good fits; none shows any symptoms of serial correlation. All the parameter
estimates carry the theoretically correct signs. In most equations we tested
some specific parameter restrictions and, when not rejected, imposed them.
Such constraints raise the precision of the estimates and also contribute to
make the simulation results more easily interpretable. In some cases, the
constraints are dictated by basic economic theory (e.g., behavioral rules for
real variables should be homogeneous of degree zero in all nominal
magnitudes), and their rejection would be a symptom of misspecification. In
other cases, they make the dynamics of the model more reasonable (for example,
when imposing a unit long-run elasticity of consumption with respect to
disposable income).
Below we describe briefly each one of the empirical equations.
Goods Market
Private Consumption - As stated in (1), the estimated equation relates
real private consumption to real disposable income and to lagged consumption;
attempts to find a significant role for the real interest rate, credit
availability, or income distribution, proved unsuccessful.
The selected equation is:
" A possible extension of this procedure would be 3SLS with different
instruments for each equation (Schmidt (1990)). Of course, this would again lead
to inconsistent estimates in all equations if any one of the model's equations
were misopecified.
33
(37) Log(Cpr) - - 0.069 + 0.578 Log(Cpr(-l))
(-2.863) (5.757)
+ 0.422 Log(Yd) - 0.194 D74
(5.757) (-5.742)
R2 - 0.964 DW - 2.105 h - - 0.320
Adj-Ra a 0.961 F = 321.545
Sample: 1961-87
2SLS. instruments a Log(Cpr(-l)). Log(Yd(-1)). Trend, D74.
The adopted specification incorporates the constraint of a unit log-run
elasticity of consumption with respect to disposable income; the constraint
was not rejected by the data.
The consumption deflator - The implicit price of consumption was assumed in
(18) a weighted average of the prices of domestic goods and imports (with the
latter adjusted for tariffs). We used a first-difference specification:
(38) ALogPc 0.893 ALogP X 0.107 ALogle*P-,(1+t)) + 0.060 d74
(26.920) (26.920) (2.261)
R2 - 0.9980 DW - 2.271
Adj-R2 - 0.9979 F - 12004.61
Sample: 1962-87
2SLS; instruments - ALogP(-1). ALog[e9P",(1+t)J(-1). Log(P%Op), d74
The weights of domestic and import prices are constrained to sum to
unity, and the regression constant is restricted to zero; neither constraint
was rejected by the data'.
Private fixed investment - As described in (4), private fixed investment is
related to Tobin's Q (defined as the stock market index relative to the
investment deflator) and the level of output relative to full capacity".
The estimated equation is of the lagged adjustment form, and is written in
" Observe that a zero constant term amounts to ruling out a long-term trend
in the relative price of consumption.
"' Capacity output was constructed by the method of interpolation of peaks.
34
terms of the (real) share of private investment in GDP:
(39) Log(lpr/Y) - 1.437 + 0.124 Log(Q) + 0.795 Log(Y/YP)
(-4.556) (2.996) (2.008)
+ 0.372 Log(Ipr(-1)/Y) - 0.472 D72
(2.849) (-3.027)
Ra 0.7493 DW - 1.723 h - 0.947
Adj-R2 - 0.7016 F - 15.693
Sample: 1962-87
2SLS; instruments c Log(Q(-1)). Lo ( Y(-1)M A?-1) ), Lo (Ipr(-1)).
LogPc~, r-2), Trend i (-I) Lo4*-1)), D72
Thus, in the long run the investment share rises more than one for one
with the degree of capacity utilization. In turn, the long-run elasticity of
investment with respect to Tobin's Q is about .2. somewhat smaller than that
obtained by Solimano (1989) from the estimation of a similar equation with
quarterly data.
The investment deflator - As in the case of consumption. the investment
deflator in (19) is a weighted average of the GDP deflator and the import
deflator. A first-difference specification proved adequate:
(40) ALogPk = 0.856 ALogP + 0.144 ALogleP*K(1+t)] + 0.099 d7172
(16.506) (16.506) (3.505)
R2 = 0.9948 DW - 2.059
Adj-R' - 0.9946 F - 4581.25
Sample: 1962-87
2SLS; instruments - ALogP(-l). Log(eOP^"(1+t)](-1), Log(P*,ep), d7172
As before, the equation incorporates the constraints that the shares of
domestic and foreign prices sum to unity and that the constant be equal to
zero; both constraints were tested and not rejected by the data.
Non-comoer eg2orts - Real non-copper exports are assumed in (6) to depend on
their relative price eP*/P - i.e., the ratio of foreign prices to the GDP
deflator -and on world demand Y', measured by real world imports from
35
developing countries again we use a lagged adjustment specification. The
estimated equation is:
(41) Log(Xnc) - 1.492 + 0.814 Log(Xnc(-1))
(-3.245) (12.565)
+ 0.308 Log(eeP*/P) + 0.186 Log(Y) + 0.517 D64
(3.068) (12.565) (3.999)
R2 = 0.9714 DW - 1.983 h - 0.047
Adj-R2 n 0.9677 F * 260.327
Samples 1961-87
2SLS; instruments = Log (Xn(-1)), Log(Y'), Log(P*,.(-1)),
Log(e*P /P)(-1), i(-1), D64
The long-run elasticity of real exports with respect to world demand is
constrained to one; the constraint was not rejected by the data. In
accordance with other studies, our empirical results indicate considerable
export inertia. The elasticity with respect to the real exchange rate is only
.308 in the short run, but in the long run it rises to about 1.6.
Imports - Real imports depend on output and on their relative price, described
by the import deflator times one plus the tariff rate divided by the GDP
deflator. Again we used a lagged adjustment specification:
(42) Log(M) = - 2.353 + 1.004 Log(Y) - 0.209 Log(e*P*m(1+t)/Pl
(-5.302) (6.983) (-4.669)
+ 0.198 Log(M(-1)) + 0.185 D7781
(2.346) (4.992)
Ra - 0.9577 DW - 2.008h u - 0.373
Adj-R' - 0.9500 F * 124.42
Sample: 1961-87
2SLS; Instruments - LogM(H-1)), Log(Y(-1)), Log(e*P'N(1+t)/P)(-1).
Log(i - )* Log(e*PFr2/PJ(-1), D7781
The estimated long-rur. el4sticity of imports with respect to real GDP is
about 1.2. The restrictioui that it be equal to one is not accepted by the
data (t-statistic=2.7). In turn, the long-run relative price elasticity is
about 0.25.
36
A&Zregate sugply - As noted above, the inverse supply schedule (9') can be
viewed as the price equation of the model, with prices determined as a markup
over variable cost, which Ln turn consists of wages and the cost of imported
materials, and with the markup rate allowed to vary with the degree of
capacity utilization. The selected specification imposes homogeneity of
degree zero in nominal prices; thus the equation is written in terms of
relative prices":
(43) Log(P/W) - 0.627 + 0.416 Log(Y(-1)/YP(-1))
(-1.059) (1.726)
+ 0.630 Log(eOPFm/P) - 0.0214 Trend + 1.630 ln(l+r)
(3.538) (-5.619) C _
+ 0.081 D6465
(2.078)
R= 0.9379 DW 2.20
Adj-R2 = 0.9192 F = 50.30
Sample: 1961-87
instruments Log[Y/YPJ(-1). Log[e-PFm/PJ(-l), Log(Ptc,p).
Trend, ln( 1+r), D6465
Here r denotes the indirect tax rate, whose coefficient was constrained
to reflect full pass-through of indirect taxes (the constraint was not
rejected by the data). Notice that the estimated equation can be rewritten
(43)' lnP = ln(l+r) + .613 lnW + .387 ln(eSPFm) + .255 ln(Y(-1)/YP(-1)) +
so that the cost share of labor is about 602, and that of materials is 401.
Our results have two important implications. First, changes in nominal
input prices are immediately passed on to goods prices, without any adjustment
lags. Second, demand pressure is reflected in prices only after a one-period
lag; hence, given input prices, final goods prices are unaffected by output
changes in the short run -- which, as we discuss below, has important
consequences for the short-run inflation-output tradeoff.
'0 We experimented with different dynamic specifications, to allow for some
inertia in the adjustment of prices to nominal production costs; however, we were
unable to identify any such effect.
37
The labor market
Emoloyment - Employment is determined by labor demand, which, according to
(12), is related to real output and to the real wage. Preliminary experiments
showed that the dynamics were adequately captured by an error correction
spec:.ication:
(44) ALog L 0.184 + 0.222 ALog Y - 0.070 Log(L(-l)/Y(-1))
(2.584) (2.446) (-2.343)
- 0.050 Log(W(-l)/P(-1)) - 0.075 D74-6,82-3 + 0.043 D8487
(-2.157) (-5.287) (4.956)
R2 = 0.924 DW 3 2.369
Adj-R2 0.902
Sample: 1962-87
2SLS; instruments = ALog Y(-1), Log[L(-1)/Y(-1)i,
Log(e*PFm/P) (-1), Log[W(-I)/P(-1)], i*, Dummies
The estimated short-run response of employment to output is only -bout
.2; however, the long run elasticity is constrained to unity; the constraint
was not rejected by the data. The long-run real wage elasticity (which can be
interpreted as the elasticity of substitution) is about .7, although not
significantly different from one.
Wages - As described earlier, the evolution of average nominal wages is
related to that of consumer prices (summarized by the consumption deflator)
and minimum wages, and to the unemployment rate. Attempts to introduce both
current and past inflation along with minimum wage growth as explanatory
variables proved unsuccessful due to the strong collinearity between one-
period lagged inflation and current minimum wage growth -- which probably
reflects the existence of formal or informal (partial) minimum wage indexation
to past inflat4.on in some portions of the sample. Faced with the two options
of keeping either minimum wages or past inflation as regressors, we chose the
former alternative, in order to retain the ability to explore the effects of
minimum wage policies in the simulation model.
38
A first-difference specification along the lines of a Phillips curve
proved adequate:.
(45) ALog W a 0.088 - 0.239 U+ 0.492 ALogPc + 0.462 ALogWmin
(4.452) (-2.051) (3.547) (3.418)
- 0.133 D64 - 0.417 D73 + 0.224 D76
(-3.071) (-5.705) (4.824)
R2 = 0.9922 DW 2.131
Adj-R2 = 0.9898
Sample: 1963-87
2SLS; instruments ALog Pc(-1), &LogPe(-2), AlogWmin(-1).
U(-1), Log(e*PFm/P)(-1), Dummies
Since minimum wage growth was found to be strongly dependent on
inflation, it is not used as an instrument in the estimationl. One feature
of the estimated equation which is worth noting is that the constraint that
the inflation and minimum wage coefficients sum to one is not accepted by the
data. This has the important consequence that a permanent increase in
inflation coupled with a nominal minimum wage increase such the real minimum
wage is unchanged, will cause a decline (although a very small one) in the
real average wage.
By excluding lagged inflation from the estimated wage equation, it may
seem that we are eliminating one potentially important source of inertia in
the wage-price system. However, what our empirical results really imply is
that in the sample the observed wage inertia was largely due to inertia in the
4 An auxiliary regression of minimum wage growth on current and past
inflation yields the following results:
ALog Wmin - -0.043 + 0.696 ALogPc + 0.304 ALogPc(-1)
(-3.141) (13 794) (13.794)
R2 a 0.9792 DW - 1.904
Adj-Ra * 0.9775
Sample: 1963-87
2SLS; instruments * ALog PJ(-1), ALogP.(-2), AlogWmin(-1),
U(-1), Log(e*PFm/P)(-1), Dummies _
39
adjustment of the minimum wage to inflation.
Assets markets
Money market - Asset equilibrium is summarized in (16') by an interest rate
equation, which can be viewed as the money market equilibrium condition
inverted to solve for the nominal interest rate. The latter is related to the
depreciation-adjusted foreign interest rate, the real money stock (measured by
M1 divided by the GDP deflator), and real output. We assume rational
expectations and replace anticipated depreciation with its actual value, which
is then treated as an endogenous variable:
,0
(47) i = 0.020 + 0.075 (i+e) - 0.578 Log(H/P)
(0.296) (3.528) (-4.552)
+ 0.578 Log(Y) + 1.691 D7576
(4.552) (11.483)
R2 = 0.9194 DW = 1.968
Adj-R' = 0.9088 F = 87.43
Sample: 1961-87
2SLS; instruments = (i*+e)(-l), Lop[H/PI(-l)1 Log(Y(-.1)). Trend,
Log(P* Op), Log(PO.p(-l)). i , Log(Y'), D7576
Viewing the equation as the money market equilibrium schedule, it can be
seen that we have imposed a unit elasticity of real money demand with respect
to output; the constraint was tested and not rejected by the data. The
semielasticities with respect to the domestic and foreign interest rates are
about 1.73 and .13, respectively; the latter result is similar to that found
by Edwards (1985) and Edwards and Kahn (1986).
Tobin's Q - As in Solimano (1989), Tobin's Q is assumed in (5) to depend on
the degree of capacity utilization and on the ex-ante real interest rate.
Experiments including the relative price of investment goods (measured by the
investment deflator relative to the GDP deflator) were unsuccessful. Also, all
our specifications performed very poorly when estimated on the full sample,
probably due to the substantial changes experienced by Chilean financial
40
markets in th3 past two decades. We wyre forced to restrict the estimation to
the post-Allende-periodg due to the scarcity of degrees of freedom, the
results must be viewed aa highly tentative.
(47) Log(Q) ' 1.314 + 5.188 Log(Y/YP) - lOiS r
(14.159) (8.957) (-2.918)
+ 0.465 D8082
(4.525)
R- 0.9608 DW - 2.144
Adj-R2 - 0.94397F - 57.158
Sample: 1976-86
2SLS; instruments - LogjY/YP](-1), r(-2), Log(Pcur), i*,
Log(Y (-1)), d8082
As before, we used the assumption of rational expectations to replace
the ex-ante real interest rate with its ex-post counterpart. The results
indicate that capacity utilization has a strong positive effect on Q, in
accordance with the results obtained by Solimano. We also find a strong
adverse effect of the real u.nterest rate.
4.3 Some implications
As we noted above, one feature of our empirical results which is worth
emphasizing is the implied shape of the short-run aggregate supply schedule.
This can be most easily illustrated by replacing equationt (44) and (45) into
(43), using the approximation U - (L'-L)/L' - ln(L'/L), and assuming all
foreign prices grow at the same rate. After some manipulations, we obtain the
following semi-reduced form equation for inflation:
(48) - - .40 AlnWmin + .56 (alne + ir) + .09 lnY + Z
where w is the domestic inflation rate (measured as AlnP), w* is the foreign
inflation rate (again measured as AlnP), and Z is a linear combination of tax
rates and predetermined variables. Thus. in the short run inflation depends
on the rate of growth of the minimum wage and on the rate of change of the
prices of foreign goods in domestic currency -- in turn given by the rate of
41
nominal depreciation plus the foreign inflation rate -- and also on the level
of economic activity.
The important fact is that the coefficient on lnY is very small -- in
other words, given the rate of growth of the minimum wage, the rate of nominal
depreciation, and world inflation, a reduction in inflation in the short run
can only be achieved at the cost of a sharp recession. More precisely, a ten
percent decline in real output leads in the short run to a decline in
inflation of less than one percent"a. This result may help understand the
developments in the Chilean economy in 1990. in which a sharp deceleration of
economic activity has had only limited short-run success in bringing down
inflation from the high levels that it had achieved as a result of the
increase, in that year, of indirect taxes, minimum wages, and world oil
prices.
Naturally, the precise form of the short-run inflation-output tradeoff
depends, as we discussed before, on the policy rules according to which the
minimum wage and the rate of nominal depreciation are determined. For
example, if the nominal exchange rate is adjusted to keep the real exchange
rate constant (i.e.. Alne - X - fr). then inflation is given by:
, = .91 AlnWmin + .20 lnY + k1*Z
where k, is a constant. This has two interesting implications: first, the
rate of inflation becomes very sensitive to changes in the nominal minimum
wage. Second, the output cost of bringing down inflation becomes lower,
although it still remains substantial: now a five percent decline in output is
required to reduce inflation one percentage point. In other words, the
aggregate supply schedule of thc economy becomes steeper under the PPP rule.
5. Out-of-samDle Policy Simulations
42 It is apparent that equation (48) allows for an inflation-output tradeoff
even in the long run, as the coefficients on the nominal minimum wage and on
foreign prices fail to sum to one. This is due to our finding of non-neutrality
in the nominal wage equation (44).
42
5.1 General Remarks
The empirical model was used to simulate the evolution of the Chilean
economy under alternative assumptions about fiscal, exchange rate, and wage
policies, as well as under different external conditions. The simulation
scenarios were chosen to illustrate different aspects of the working of the
model, and not necessarily because of their likelihood or realism.
In all the simulations, the external environment is exogenously given.
This comprises the evolution of world demand Y% the foreign interest rate i*,
and the world prices of imports as well as those of copper and non-copper
exports (P*H.P*,op and P1. respectively). Real copper exports follow an
exogenously given path. Similarly, profit remittances, net transfers from
abroad and direct foreign investment are all exogenously projected in foreign
currency terms. We also assume no debt conversions. The time path of the
foreign debt stock is given exogenously, to reflect the limited availability
of external financing. Finally, the interest rate on foreign debt is assumed
to carry a 1 percent spread over LIBOR.
Among the fiscal variables, tariff rates are assumed to remain unchanged
throughout the simulation period. In turn, the indirect tax rate also remains
constant, after an initial increase in 1990 (see below). The items 'Other
government revenues' and 'Other public expenditures' are assumed to remain
constant as percentages of GDP. Copper revenues are endogenously determined,
as we described above, although the volume of public copper production is
exogenous. Real public investment grows at a constant rate throughout the
simulation period. On the other hand, the public sector deficit is assumed to
be entirely financed by foreign debt. No amortization on the Treasury note is
paid after 1990.
This leaves as fiscal policy variables real public consumption and
direct taxes. Because of the flexibility of the simulation model, their time
paths can be either exogenously given (e.g., in terms of fixed real growth
rates), or related to other endogenous variables according to appropriate
policy rules (e.g.. public consumption can be determined so as to achieve a
43
prescribed public savings/GDP ratio)". Which of these alternatives is
adopted depends on the specific simulation scenario under study.
The same applies to the remaining policy variables: the nominal exchange
rate, the money stock, and the legal minimum wage. Their time path can also be
specified either in the form of a given rate of growth, or according to a
policy rule (e.g., a crawling peg for the nominal exchange rate).
In the monetary accounts, the money multiplier is assumed constant. Base
money growth is specified exogenously, and foreign reserves are obtained from
the Balance of Payments (as the aggregate foreign debt stock is exogenously
projected). We also assume that the Central Bank's foreign debt stock remains
constant; hence, its budget identity endogenously determines the time path of
net credit (or, more accurately, net debt) to the private sector dcpr.
To complete the simulation model, we must also specify the evolution of
some other variables. These include the labor force, which is assumed to grow
at a constant rate. and real inventory investment, which is assumed to remain
constant as a ratio to real GDP throughout the simulation period.
Finally, it is important to note that in the simulations we assume
static expectations for inflation and for nominal exchange depreciation. This
has the advantage of enormously simplifying the solution of the model. Under
rational expectations, it can be shown that in our model current endogenous
variables would depend on the current and future anticipated values of all
exogenous variables; thus the model would have to be solved using a 'multiple
shooting' technique in order to find the convergent trajectory.
The mode. was simulated using 1989 as the base year. This introduces
some complications, since 1989 was a 'boom' year -- particularly for
investment and imports (and also non-copper exports). and also in terms of a
spectacular increase in the accumulation of inventories. The boom could be
43 Of course, these degrees of freedom only exist for the near term. In the
long run, the setting of the two variables has to satisfy the additional
constraint of providing the primary budget balance required to avoid an explosive
path for publ'.c debt, as we noted before. Since in the simulations below we are
only concerned with the short to medium term, and since the simulated model is
backward-looking, we need not concern ourselves with this problem here.
44
explained mainly by the stimulative monetary policiee adopted in 1988. and
perhaps also by anticipations of possible trade restrictions and/or of real
depreciation.
To reflect the expected cooldown of the economy in 1990. we introduced a
downward adjustment in the accumulation of inventories, which for the
simulations is fixed at 0.3 percent of real GDP. down from 3.3 percent in
1989. This amounts to a once-and-for-all adverse shock to aggregate demand,
which results in an economic slowdown in 1990; however, since in the empirical
model some of the components of aggregate demand display substantial inertia
(consumption, investment, exports). this may not eliminate completely the
lagged effects of the 1989 boom.
In all the scenarios we assumed some monetary and fiscal adjustment in
1990. Direct taxes rise 1.5 percentage points of GDP in 1990. and the indirect
tax rate rises 2 percent in the same year. Monetary policy is transitorily
restrictive in those two years, with money growth proceeding at a constant
rate thereafter. Similarly, the minimum wage is increased by 26 percent in
1990" .
5.2 The simulation scenarios
Below we present the results of five simulation scenarios. The first one
is a reference or 'base' scenario, which is mainly used as a benchmark for the
purposes of comparison. The second and third scenarios simulate the effects of
'internal shocks': a fiscal expansion, and an increase in minimum wage growth,
respectively. Finally, the fourth and fifth scenarios explore the effects of
two adverse 'external shocks': a fall in copper prices, and an increase in oil
prices. Although both represent terms-of-trade disturbances, the latter
scenario adds to the picture the ingredients of a supply shock.
(i) The Base Scenario
" This is the approximate equivalent in annual terms to the 40 percent
increase that took place in Hay.
45
The base scenario represents a 'reference' case, and does not
necessarily correspond to a 'most likely' scenario. Fiscal policy is assumed
moderately restrictive: after the tax adjustment described above, direct taxes
remain constant as a percentage of GDP. while real public consumption and
investment rise at the constant rates of 1 and 4 percent per year,
respectively"'.
The assumed time path of copper prices deserves some attention. The
world price is assumed to fall about 15 percent in 1990, followed by an
additional 10 percent fall in 1991. In 1992 it stays at this new value, and
thereafter it grows at the assumed rate of world inflation (which throughout
equals 5 percent). This amounts to a total fall of about 34 percent in the
relative price of copper in terms of other foreign goods over the simulation
period, from the very high levels achieved in 1989-90.
We also assume that the nominal exchange rate follows a 'crawling peg',
to achieve a modest 1 percent real depreciation per annum. Finally, wage
policy is summarized by the rate of change of the nominal minimum wage. which
slows down gradually after 1990 (when it equals 26 percent), to reach 22
percent in 1991 and 20 percent per annum in 1992-95.
(ii) Internal shocks
Fiscal expansion
In this scenario we explore the consequences of a balanced-budget
expansion in public consumption. In 1990-92 real public consumption rises by
one percentage point of GDP per annum, relative to the bass scenario; it then
remains constant as a share of GDP. The expansion is entirely financed by a
direct tax increase, so as to leave the public deficit/GDP ratio unchanged
from its level in the base scenario. All other exogenous variables and policy
rules are the same as in the base scenario, so that, in particular, the path
of the real exchange rate is unchanged (by appropriately adjusting the nominal
" This expansion of public consumption may seem too slow at first sight;
however, it represents an expansionary change when compared vith the recent
trend. as public consumption declined in real terms in 1985-89.
46
rate of depreciation).
Minimum Wate Increase
This scenario investigates the consequences of a faster rate of minimum
wage growth. We raise the latter to 25 percent in 1991-95; recall that in the
base scenario the minimum wage rose by 22 percent in 1991 and at a constant
rate of 20 percent in 1992-95. To avoid an excessive increase in inflation,
and also to explore the impact of the higher wage growth on the real exchange
rate, we assume the same nominal depreciation as in the base scenario. All
other exogenous variables and policy rules are identical to those in the base
scenario. In particular, it is important to emphasize that the time path of
public consumption is left unchanged, so that we are implicitly assuming that
the wage policy change refers mainly to the private sector's wage.
(iii) External Shocks
Fall in copper prices
This scenario is based on more pessimistic assumptions about the
trajectory of the world price of copper. The latter is the same as in the
base scenario for 1990. but in 1991 it is assumed to fall by 20 percent
(compared with 10 percent in the base scenario), and in 1992 by a further 10
percent (it was unchanged in the base scenario). It then stays constant in
1993 at this level, and in 1994-95 rises at the world rate of inflation (5
percent). Overall, the assumed trajectory represents a 50 percent decline in
the relative price of copper in terms of other foreign goods, about 15 percent
more than in the base scenario.
We also assume that the adverse effect on public finances of the fall in
copper revenues is partially offset by fiscal adjustment. In particular,
public consumption declines with respect to the base scenario by half of the
loss in copper revenues, so that only 50 percent of the latter is reflected in
a fiscal imbalance. The remaining exogenous variables and policy rules are
the same as in the base case.
47
Oil shock
In the final scenario we investigate the consequences of a permanent oil
shock. We assume that the price of oil rises 13.3 percent46 in 1990. and an
additional 12 percent in 1991; thereafter, it rises at the world rate of
inflation. In the long run, this amounts to about a 15 percent increase in
the relative price of oil in terms of other foreign goods.
Oil is implicitly included in the model as part of the composite import
commodity and also in the imported intermediate input. Thus, the oil price
increase is reflected in an increase in the foreign-currency prices of
aggregate imports and of imported materials. The former rises by a percentage
determined by the share of oil imports in total imports, times the oil price
increase. The latter rises by the share of oil in materials imports times the
oil price increase.
Finally, to isolate the macroeconomic impact of the oil price shock, we
assume that no macroeconomic adjustment measures are taken; in particular, the
rate of nominal depreciation, and the time paths of the fiscal policy
variables, are the same as in the base scenario. The remaining exogenous
variables and policy rules are also unchanged.
5.3 Simulation Results
Base Scenario
The results of the base scenario are summarized in Table 5.1. The
combined effect of the monetary and fiscal adjustment measures, along with the
assumed fall in the demand for inventories. result in a drastic slowdown of
the economy in 1990. Real GDP growth falls to 3.3 percent. while inflation
rises to almost 30 percent due to the combined effect of the minimum wage
increase, the accelerated rate of nominal depreciation required to maintain
the real exchange rate, and also as a consequence of the 1989 boom (see
equation (4.7)' above). Despite the slowdown, the current account balance
" That is, a 40 percent increase during the last four months of the year,
which amounts to 13.3 percent in annual terms.
48
shows a substantial deterioration, rtly due to the assumed fall in copper
prices. The budget surplus of the nunfinancial public sector also declines,
while the inflationary push and the assumed real depreciation lead to a
reduction in the real wage despite the increase in the minimum wage.
After the 1990 slowdown, there is a recovery. This ia due to the
combined effect of the inertia of aggregate demand -- in particular, exports
and private investment are still growing at high rates --. to the absence of
further contractionary tax increases, and also to the sustained real
depreciation. The rate of growth of real GDP rises to 5.8 percent in 1991,
and then declines gradually to stabilize around 4.8 percent, while inflation
decelerates in 1991 -- due to the economic slowdown of 1990 -- and then
remains around 17 percent. The current account deficit also narrows, to reach
4.3 percent in 1995. The public surplus is still falling in 1991-92 along
with real copper prices, but starts to rise again when they bottom out; it
reaches about 2.5 percent of GDP in 1994-95. In turn, the real wage rises by
six percentage points over the simulation period, despite the assumed real
depreciation.
Fiscal expansion
The results of this simulation can be more easily understood with the
help of Figure 2. Assume that in the base scenario the economy started from
the situation depicted by point A, at the intersection of the SS and DD
schedules; hence, the CA schedule passing through point A corresponds to the
current account deficit achieved in the base scenario. Now there is a fiscal
expansion, and hence the DD schedule shifts to the right, to a position such
as D'D' in the figure. If this were all, then the result would be at output
expansion and a real appreciation relative to the base scenario, together with
a current account deterioration; that is, we would reach a point such as B.
However, since we have assumed that nominal depreciation is raised so as to
keop the same real exchange rate path as In the base scenario, point B cannot
be the final outcome; rather, the additional depreciation combined with
49
unchanged minimum wage growth leads to a fall in real wages (see equation (22)
above)", that shifts the supply schedule to S'S'; thus, the final
equilibrium must be achieved at point C, where the real exchange rate is
unchanged at its initial value, and the output expansion is further increased
to y1.
The numerical results of the simulation appear in Table 5.2. The fiscal
stimulus, which develops in 1990-92, raises GDP growth in those years by about
1.5 percentage points above Its level in the base scenario; as the fiscal
impulse comes to a halt in 1993-95. the economy slows down, with growth
falling below its level in the base scenario; GDP growth eventually stabilizes
at 4.3 percent. The additional demand pressure causes also a transitory
inflation increase relative to the base scenario. which disappears in the long
run as real growth slows down. The increased growth is reflected in the
current account deficit, which shows a persistent deterioration relative to
the base scenario. The external imbalance averages about 7 percent of GDP
over the simulation period, and peaks at 7.7 percent in 1994; it eventually
starts declining in 1995.
By construction, the real exchange rate and the public deficit remain
unchanged at their values in the base scenario. In contrast, the additional
inflation - given the path of the nominal minimum wage - leads to slower real
wage growth, so that in 1995 the real wage is 1 percent lower than it was in
the base scenario.
Minimum wage increase
The effects of the minimum wage increase are illustrated in Figure 3.
With the given rate of nominal depreciation, the immediate consequence is an
increase in the real wage (see (22) above), that shifts the SS schedule to the
left. The result is a real appreciation, an output contraction, and a current
" The additional depreciation with unchanged monetary growth also leads to
a reduction in the real money stock (see (21) above), and hence to a
contractionary shift of the DD schedule. We have ignored this to avoid cluttering
the figure. The net result etill is a rightward shift of the DD schedule.
50
account deterioration relative to the base scenario.
The numerical results appear in Table 5.3. They show a reduction in real
GDP growth, which now falls after the transitory recovery of 1991; it
eventually stabilizes at 3.7 percent in 1994-95. Inflation shows a parallel
increase over its level in the base scenario; it averages about 18.5 percent
at the end of the simulation period.
The real exchange rate stays now practically unchanged from its level in
1990; this amounts to a real appreciation of more than 6 percent in 1995
relative to the base scenario -- which is also the extent of the real wage
increase in 1995. This leads to a significant current account deterioration
despite the growth slowdown, with the external deficit now reaching 5.5
percent of GDP in 1995, compared with 4.3 in the base scenario. This is
partly due to a worsening of the fiscal balance, which results mainly from the
reduced real copper revenues that follow from the real appreciation; the
fiscal surplus is now reduced to 1.9 percent of GDP in 1995, compared to 2.6
percent in the base scenario.
Copper orice fall
As in the previous scenarios, we can use Figure 4 to illustrate the
qualitative consequences of the copper price fall. The terms.of trade
deterioration relative to the base scenario shifts the CA schedule to the
left, as now a more depreciated real exchange rate is required to keep the
same current account deficit as in the base scenario. However, under our
assumption of partial fiscal adjustment the aggregate demand schedule also
shifts to the left to DID', reversing part (but not all) of the external
accounts deterioration through a fall in output and a real depreciation; this
would take the economy to a point such as B in the figure. But to this we must
add the reduction in nominal depreciation that is required to keep the real
exchange rate unchanged, as assumed; together with the unchanged wage
behavior, this implies a real wage increase that shifts the SS schedule to the
51
left, reducing output even further and preventing the real depreciation'8.
The final equilibrium would be at point C.
The numerical results of ti' simulation are sualarized in Table 5.4.
The fall in copper prices forces a fiscal retrenchment starting in 1991, that
causes a persistent fall in GDP growth relative to the base scenario; the
growth decline averages about 0.8 percentage points in 1991-95. As public
expenditure is reduced, so is the pressure of aggregate demand, and hence
inflation shows a moderate reduction relative to the reference scenario -
which is also reflected in a somewhat higher real wage.
Since the fiscal adjuetment does not fully offset the reduction in
copper revenues, the public surplus declines; by 1992, it has been almost
entirely wiped out. In 1995. the deterioration in public finances relative to
the base scenario amounts to almost 1 percent of GDP. The current account also
deteriorates; the external deficit now exceeds 7 percent of GDP in 1991-94,
and in 1995 it is more than two points higher than in the base scenario.
Oil price increase
The diagrammatics of this scenario are depicted in Figure 5. As in the
case of the copper price fall, the adverse terms of trade shock shifts the CA
schedule up and to the left, to CA'CA'. However, the oil shock is also an
adverse supolv shock, that shifts the SS schedule to the left, leading to a
real appreciation, a fall in output, and a further current account
deterioration. The final equilibrium is at a point such as B.
The numerical results for this simulation are summarized in Table 5.5.
The oil shock, which takes place in 1990-91, leads to an immediate slowdown in
economic activity: in 1990, real GDP growth falls by about 0.5 percent
relative to the base scenario, and by one percentage point in 1991-92.
Inflation rises in 1990-91 above its level in th'% reference scenario, but then
declines due to the economic deceleration; in 1995 it equals 17 percent.
'$ Symmetrically with the fiscal expansion scenario, the reduced nominal
depreciation together with unchanged money growth raises real balnncee,
moderating the contractionary shift of the DD schedule.
52
compared with 17.4 in the base scenario. As in the wage increase scenario,
higher inflation.combined with unchanged nominal depreciation lead initially
to a real appreciation, that is later partially reversed. However, in 1995
the real exchange rate has appreciated by over 4 percent relative to the
reference scenario.
As a consequence of the terms of trade shock and of the real
appreciation, the current account suffers a sharp deterioration, with the
deficit peaking at 6.9 percent of GDP in 1991. and remaining above 6 percent
throughout the simulation period. As before, the real appreciation has also
the effect of reducing real copper revenues, and the fiscal surplus declines
relative to the base scenario. The real wage also declines, due to the
erosion caused by increased inflation with an unchanged minimum wage growth,
and to the additional unemployment (relative to the base scenario) generated
by the reduction in growth.
6. Final Remarks
In this paper we have constructed, estimated, and simulated a
macroeconometric model for Chile. The model a'llows for the interaction of
aggregate supply and demand factors in the determination of the key
macroeconomic variables, such as real output and employment. inflation, the
real exchange rate and the real wage. and the current account balance. It
ensures the full consistency of the different macro aggregates, by imposing
the relevant budget constraints on the fiscal sector, the Central Bank, and
the Balance of Payments. To this consistent framework, the model adds a set
of behavioral equations with sound analytical foundation3.Thus, the model
provides a porentially useful tool for the design and evaluation of
macroeconomic policy.
The behavioral equations were empirically estimated using annual data
for Chile. The results are in general quite encouraging: the model tracks the
observed values of the endogenous variables with a high degree of accuracy,
and its qualitative properties are well in lir.e with the predictions of
53
macroeconomic theory.
The model was simulated to explore the effects on the evolution of the
economy of different internal and external disturbances: a balanced-budget
fiscal expansion, a policy of increased minimum wage growth, a fall in world
copper prices, and an oil price shock. These simulations attempt to
illustrate the effects of domestic policies and external shocks that shape the
current policy discussion in Chile.
54
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57
*a I
AS
CA E'
AD
I~~~~~~~~~
(a) A Fiscal Expansion
AS
K'
CA
AD
y
(b) Devaluation
5P
Figure 1
eR
AS
AD . /
y
(a) A Fiscal Expansion
AS
]AD
(b) Devaluation
Table 5.1
Simulation results 1990-95: Base Scenario
Real GDP Inflation Curr. Account Nfps Real Exch. Real
Year Growth Rate' Deficitb Deficit4 Rated Wage*
1989' 10.0 13.3 3.0 -2.9 100.0 100.0
1990 3.3 29.6 5.3 -2.5 101.0 97.8
1991 5.8 15.3 5.5 -2.0 102.0 100.2
1992 5.6 16.4 5.4 -1.9 103.0 £01.8
1993 5.3 17.0 5.0 -2.2 104.1 103.4
1994 4.7 17.3 5.3 -2.4 105.1 105.0
1995 4.8 17.4 4.3 -2.6 106.2 106.9
Notes: a - GDP Deflator
b - As percentage of GDP
c - Deficit of the non-financial public sector, as percentage of GDP
d - Increase means depreciation
e - In terms of the consumption deflator
f - Actual values
A it it
I I
4 ~~~I I
I, ~~~~II I
I~~~~TU
OTZlUflU ,UOTSUUUG 1103;; rn%
I
U9
61
Table 5.2
Simulation results 1990-95: Fica_l ExVanljon
Real GDP Inflation Curr. Account Nfpe Real Exch. Real
Year Growth Rate' DefAEcitb RaiA&W R.te4 Wage
1989' 10.0 13.3 3.0 -2.9 100.0 100.0
1990 4.7 29.8 5.7 -2.5 101.0 97.8
1991 7.5 16.9 6.6 -2.0 102.0 99.7
1992 7.1 18.4 7.3 -1.9 103.0 100.6
1993 5.3 18.7 7.2 -2.2 104.1 101.7
1994 4.3 17.6 7.7 -2.4 105.1 103.6
1995 4.3 17.3 6.9 -2.6 106.2 105.9
Notes: a - GDP Deflator
b - As percentage of GDP
c - Deficit of the non-financial public sector, as percentage of GDP
d - Increase means depreciation
e - In terms of the consumption deflator
f - Actual values
62
Figure 3
The 'minimum wage increase' scenario
eR
S I
A~~~C
CA
1s^~~~~~
S) S I
I~~~~~~~~~~~~~~~~
6 3
Table 5.3
Simulation results 1990-95: Minimum Wa&e Increase
Real GDP Inflation Curr. Account Nfp. Real Exch. Real
Year Growth Rate' Deefictb Deflcit' Rate4 WaIe'
1989' 10.0 13.3 3.0 -2.9 100.0 l00.0
1990 3.3 29.6 5.3 -2.5 101.0 97.8
1991 5.6 16.4 5.6 -1.9 101.1 100.8
1992 5.1 18.1 5.7 -1.6 100.6 103.4
1993 4.5 18.6 5.6 -1.7 100.2 106.1
1994 3.7 18.7 6.2 -1.8 100.0 108.9
1995 3.7 18.6 5.5 -1.9 99.9 112.0
Notes: a - GDP Deflator
b - As percentage of GDP
c - Deficit of the non-financial public sector. as percentage of GDP
d - Increase means depreciation
e - In terms of the consumption deflator
f - Actual values
64
Figure 4
The 'copper price fail' scenario
eR S Tb1I
St ~~~~~~~CA'
*CA6;,
b I
y
65
Table 5.4
Simulation results 1990-95: Cooper Drice fall
Real GDP Inflation Curr. Account Nfps Real Exch. Real
Year Growth Rate' Deficitb Deficit' Rated Wage'
1989, 10.0 13.3 3.0 -2.9 100.0 100.0
1990 3.3 29.6 5.3 -2.5 101.0 97.8
1991 5.0 15.2 6.5 -1.4 102.0 100.2
IS92 4.8 15.5 7.1 -0.1 103.0 102.1
1993 4.7 16.0 7.0 -1.0 104.1 104.0
1994 4.3 16.5 7.4 -1.2 105.1 105.8
1995 4.5 16.7 6.4 -1.5 106.2 107.7
;lotes: a - GDP Deflator
b - As percentage of GDP
c - Defi-it of the non-f inancial public sector, as percentage of GDP
d - Increase means depreciation
e - In terms of the consumption deflator
f - Actual values
66
Figure 5
The 'oil shock' scenario
eO I
c 5
y
67
Table 5.5
Simulation results 1990-95: 01 Shock
Real GDP Inflation Curr. Account Nfps Real Exch. Real
Year Growth Rates Deficitb Deficit' Rated Wage
1989' 10.0 13.3 3.0 -2.9 100.0 100.0
1990 2.9 33.7 5.8 -2.1 97.9 96.1
1991 4.8 18.1 6.7 -1.3 96.5 97.2
1992 4.5 15.9 6.9 -1.2 97.9 98.8
1993 4.3 16.5 6.6 -1.5 99.2 100.4
1994 3.9 16.9 6.9 -1.7 100.6 102.1
1995 4.1 17.0 6.0 -1.9 101.9 103-8
Notes: a - GDP Deflator
b - As percentage of GDP
c - Deficit of the non-financial public sector, as percentage of GDP
d - Increase means depreciation
e - In terms of the consumption deflator
f - Actual values
6,R
SIMULATION RESULTS 1990-95
REAL GDP GROWTH
DOMESTIC SHOCKS
REAL GDP GROWTH
12
10
V- 0FISCAL EXPANSION
6
BASE SCENARIO
4
WAGE INCREASE
2 !I L l
1989 1990 1991 1992 1993 1994 1995
YEAR
OEC4GO0 PQ
SIMMSWK
GOPO ObW
69
SIMULATION RESULTS 1990-95
INFLATION RATE (GDP Deflator)
DOMESTIC SHOCKS
INFLATION RATE
35
30
20K
20[- \ FISCAL EXPANSION WAGE INCREASE
15 _
15 BASE SCENARIO
10
1989 1990 1991 1992 1993 1994 1995
YEAR
OEC-340 PC
SWMWK1
tfLONW
7n
SIMULATION RESULTS 1990-95
CURRENT ACCOUNT DEFICIT/GDP
DOMESTIC SHOCKS
CAD/GDP
8
FISCAL EXPANSION
WAGE INCREASE
5
| W~~~~~~~~ASE SCNARi E
4
1990 1991 1992 1993 1994 1995
$.qS WKI-
YE0ASE
IOEC.340 FO
CAO.:RW
'11
SIMULATION RESULTS 199095
GOVERNMENT DEFICIT/GDP
DOMESTIC SHOCKS
GOVERNMENT DEFICIT/GDP
(1.4)
(1.6) S WWAGE INCREASE
I- $ -.
(-8) F,
BASE SCENARIO
(2) -,
(2.2) - '
(2.4)
(2.6)
(2.8) '
1990 1991 1992 1993 1994 1995
YEAR
DEC.39o0 FO
SiMRES WKC
GOEF DRW
72
SIMLU.'ATION RESULTS 1990-95
REAL EXCHANGE RATE
DOMESTIC SHOCKS
REAL EXCHANGE RATE
107
BASE SCENARIO
106 _
ios~~~/ i
1045
L
103
102
101 -.
100 / - .,, WAGEINCREASE
100 '----.. .
99 filL
1989 1990 1991 1992 1993 1994 1995
YEAR
OEC.340 O
060-35.W10
84wox
73
SIMULATION RESULTS 1990-95
REAL WAGE
DOMESTIC SHOCKS
REAL WAGE
114
1 12 WAGE INCREASE I
1.1
110
108 k
106~~~~~~~~~~~BS SCENARIO
104 _,'.
102 _, '..FISCAL EXPANSION'
100 )/"-""-
98 - -
96 I I
1989 1990 1991 1992 1993 1994 1995
YEAR
UsA'm WKI
WROW
74
SIMULATION RESULTS 1990-95
REAL GDP GROWTH
EXTERNAL SHOCKS
REAL GOP GROWTH
12
1 0 \
8 L
6 L
BASE SCENARIO
L \ , ~~~COPPER PRICE FALLj
.... ...............
4 .W'..' OIL PRICE INCREASE ; =.|
2 E. ..I I L _ l..
1989 1990 1991 1992 1993 1994 1995
YEAR
aCt-Mil
_ -I
owa_M
75
SIMULATION RESULTS 1990-95
INFLATION RATE (GDP Deflator)
EXTERNAL SHOCKS
INFLATION RATE
35
OIL PRICE INCREASE
30-
25
20
BASE SCENARIO
15 0/ .... . ---' '' ... COPPER PRICE FALL
10 I I
1989 1990 1991 1992 1993 1994 1995
YEAR
oo0310 Po
SMMB.WKI
gem-ONW
76
SIMULATION RESULTS 1990-95
CURRENT ACCOUNT DEFICIT/GDP
EXTERNAL SHOCKS
CADiGDP
8
7.5 ---OCO PPER PRICE FALLi
6.5- _ - . :., *.-....... .. . S .
6 , _ OIL PnICE INCREASE
5.5 -- -~ --.BASE SCENARIO
4.5
41
1990 1991 1992 1993 1994 1995
YEAR
w.4
77
SIMULATION RESULTS 1990-95
GOVERNMENT DEFICIT/GDP
EXTERNAL SHOCKS
GOVERNMENT DEFICIT/GDP
0
.e.
(0.5) _ , ..
' COPPER PRICE FALL
(1.5) /1 *II ~~~~~.............. .......~*
OILPRICE INCREASE
BASE SCENARIO
(2)
(2.5) _ .. .
1990 1991 1992 1993 1994 1995
YEA
mc-s Fo
7 F
SIMULATION RESULTS 1990-95
REAL EXCHANGE RATE
EXTERNAL SHOCKS
REAL EXCHANGE RATE
108
106
104
BASE SCENARIO
102
100
OIL PRICE INCREASE o
98 . ._.
96 IlIIi .l
1989 1990 1991 1992 1993 1994 1995
YEAR
am~~~~~~~~~
vg¢tHo~~~~~~~~~ so
_.~~~~~~~~~~~~
U~~~~~~~~~~~~~~ -n
79
SIMULATION RESULTS 1990-95
REAL WAGE
EXTERNAL SHOCKS
REAL WAGE
108k 0COPPER PRICE FALL
106
BASE SCENARIO
104
102
OIL PRICE INCREASE
100
98
96
94
1990 1991 1992 1993 1994 1995
YEAR
OEC-3-9 FO
SaMS WK
Wvws ORW
'ontact
milf Akhor D)ate X .
WPS689 Do Tax Policies Stimulate Investment Anwar Shah May 1991 A Bhaila
in Physical and Research and John Baffes 37699
Development Capital9
WPS690 The Terms-of-Tiade Effects from the Gabor Oblath May 1991 J. Smith
Elimination of State Trading in Soviet- David Trar 37350
Hungarian Trade
WPS691 Can Debt-Reduction Policies Resfore Jacques Morisset May 1'l S l