Abstract
This Selected Issues paper examines the acceleration of inflation over the past year in Chile, identifying domestic shocks to food and energy prices as main drivers. The paper uses the Jeanne-Rancière model to calculate Chile’s optimal ratio of international reserves to GDP. It analyzes the stabilization properties of Chile’s macroeconomic framework and compares it with alternative policy rules. The paper concludes that Chile’s framework based on an explicit inflation target, a floating exchange rate, and a structural fiscal surplus rule is superior to other arrangements.
IV. How Do Changes In Global Liquidity Affect Chile?1
As financial globalization progresses, changes in global liquidity have become increasingly important determinants of expenditure and pricing patterns around the world. Staff analysis suggests that trends in global liquidity can positively affect financing conditions and growth in the four Latin American countries under study.
1. This chapter analyzes the impact of changes in global liquidity on Latin American countries with a special focus on Chile. The impact is quantified by estimating structural VAR models for four countries, namely Argentina, Brazil, Chile, and Mexico, using 1997–2007 data. For each country, the model includes a variable capturing global liquidity and a set of five domestic variables: output growth, the inflation rate, interest rate, equity returns, and the nominal effective exchange rate.2
2. Three liquidity measures are used to ensure that results are robust to the definition of global liquidity. The first measure is the world money stock (U.S. M0 money plus the sum of world international reserves), assuming that the world economy is fully integrated and can thus be portrayed as a closed economy.3 The second approach measures banks’ funding liquidity using the G7 Ted spread (Libor minus T-bill rate). The third and final metric uses the VIX index to reflect the speculative motive of liquidity holding at a global level.4
3. By running impulse response functions for shocks to these liquidity measures, we are able to gauge the response of each country to changes in global liquidity. These shocks are derived by estimating univariate autoregressive residuals of the metrics described above. These residuals are found to be generally uncorrelated with each other—suggesting that they indeed reflect different concepts of liquidity.
4. The findings tally with economic theory, with results similar across liquidity measures but different across countries. As expected, positive global liquidity shocks tend to lower interest rates, increase equity return and output at home, and reduce the global interest rate or global risk premium—allowing countries to borrow more easily and on cheaper terms. More favorable financing conditions in each economy, in turn, stimulate economic activity. Given faster growth and lower interest rates, equity returns also increase.
5. Other key results from the analysis can be summarized as follows:
Global liquidity contracted substantially during the recent international financial turmoil. As expected, the measure using Ted spreads was most affected as the sub prime crisis primarily hit the financial sector. Liquidity proxied by the VIX index also worsened significantly, reflecting a spike in risk premia. Likewise, global liquidity measures proxied by world international reserve growth also slowed—after years of rapid growth—but appears to have been affected less than the other measures.
Notwithstanding the similarities noted above, the magnitude of response and speed of convergence after a global liquidity shock differ across countries. Chile’s output and inflation, for example, return quickly to equilibrium following the shock to global liquidity, and the economy is rather resilient to the shock. Mexico and Brazil have similar but somewhat more persistent responses. In contrast, the model for Argentina shows departures from equilibrium that are larger and more protracted.
Impulse response functions to other shocks are also different across countries. In Chile, short-term interest rates increase immediately in response to shocks to either inflation or growth, and by a significant amount, indicating that monetary policy responds actively to inflationary pressures. In Mexico, interest rates respond to inflation in a similar way, but not as much to output. The response of Brazilian short-term interest rates to inflation has been somewhat slower, although the reaction speed appears to have increased in the second half of the sample period. Model results for Argentina generally show a strong reaction of the exchange rate in addition to the interest rate response.
Global liquidity conditions
Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A004
6. These results support the notion that inflation targeting is a powerful stabilizing force in the presence of global liquidity shocks. While the initial magnitude of the response to a change in global liquidity may reflect the degree of each country’s dependence on external finance, the speed at which each country returns to equilibrium seems to depend primarily on the country’s interest rate reaction—which in turn is highest for countries that have adopted an inflation targeting regime.
Response to Global Liquidity Shocks
Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A004
Response to Other Shocks (Chile Only)
Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A004
This chapter is a summary of a paper prepared by Akito Matsumoto (RES).
We assume that the global liquidity conditions are exogenous to the country. In theory, this is in line with the assumption that each small open economy does not affect world variables.
Using world international reserves is preferable to using the G7 money stocks, in part because the former capture recent important additions to global liquidity from the accumulation of saving in commodity exporting countries and East Asia.
The liquidity measures are used separately to obtain three versions of each country model. All measures are transformed in such a way that positive values imply expansionary economic effects.
