Macroeconomic Policy and Economic Performance: Chile’s Recent Experience

1. Macroeconomic Policy and Economic Performance: Chile’s Recent Experience Luis F. Céspedes Ministry of Finance-Chile

2. Macroeconomic Policy and Stabilization • External shocks, such as terms of trade and world interest rate shocks are key driving forces behind business cycle in emerging market economies. • Economic stabilization depends crucially on the macroeconomic framework: monetary policy, fiscal policy and exchange rate regime. • Reaction to shocks: countercyclical or pro-cyclical? • Maintain (reduce) interest rates and allow depreciation? • Raise interest rates to avoid depreciation and inflation? • Expansionary fiscal policy?

4. Chile: Policy Framework • Flexible Inflation Targeting • Inflation target band: 2-4%. • Medium run horizon. • Free-floating exchange rate regime. • Foreign exchange interventions under special circumstances. • Fiscal Rule • Structural fiscal balance

5. Chile: Policy Framework • Recent evidence indicates that macroeconomic volatility has been significantly reduced in recent years. • The implementation of a flexible and credible inflation targeting regime has allowed monetary policy to play a key stabilizing role. • Fiscal Policy has also been key to reduce the effects of external shocks in activity and in the competitiveness of the economy.

6. GDP volatility has decreased in recent years Sources: Ministry of Finance and Central Bank of Chile.

7. Central Bank has been able to implement a countercyclical monetary policy Sources: Ministry of Finance and Central Bank of Chile.

8. Fiscal Policy • A credible fiscal policy is crucial to isolate government expenditure from economic fluctuations. • During booms, higher fiscal savings reduce pressures on aggregate demand which stabilizes economic activity and the real exchange rate. • Evidence indicate that in many developing economies, fiscal policy is pro-cyclical. Moreover, it is common that fiscal expenditure increases in a higher proportion than fiscal revenues during good times.

9. Fiscal Policy in Chile • Government expenditures are determined by medium and long term fiscal revenues (structural revenues). • Structural revenues are a function of potential output and the “reference” price of copper. • During recessions the government borrows and during expansions it saves.

10. Fiscal Policy in Chile

11. 400 350 300 250 200 150 100 50 Jul-01 Jul-00 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Ene-01 Ene-00 Ene-02 Ene-03 Ene-04 Ene-05 Ene-06 External conditions have been favorable for the Chilean economy in recent years. Fuente: Cochilco

12. Fiscal Policy in Chile

13. Fiscal Policy in Chile

14. By increasing fiscal saving during good times, fiscal policy has reduced the appreciation of the RER Sources: Ministry of Finance and Central Bank of Chile.

15. Real Exchange Rate 115 115 110 110 105 105 100 100 95 95 90 90 85 85 80 80 75 75 Jun-86 Jun-90 Jun-94 Jun-98 Jun-02 Jun-06 Average 1990-2006 RER RER Fuente: Banco Central.

16. Gross Debt Public Sector(% of GDP) Source: Ministry of Finance

17. Portfolio management has also being consistent with keeping “competitiveness” of the economy

18. The Fiscal Responsibility Law • Complements the Structural Balance Rule by focusing on the management of the financial assets generated by the implementation of the rule. • Includes the creation of two funds: the pension reserve fund and the economic and social stabilization fund. • Improves transparency of fiscal policy and financial asset management. • Empowers the Government to capitalize the Central Bank.

19. PENSION RESERVE FUND • 0.2% of GDP minimum • 0.5% of GDP maximum • CAPITALIZATION OF THE CENTRAL BANK • 0.5% of GDP for 5 years FISCAL SURPLUS • ECONOMIC AND SOCIAL STABILIZATION FUND • Accumulates all of the surplus that exceeds 1%of GDP