Capital Flows and Long-Term Equilibrium Real Exchange Rates in Chile

  • Ibrahim Elbadawi The African Economic Research Consortium
  • Raimundo Soto ILADES/Georgetown University

Abstract

This paper examines. in the context of an empirical model. the impact of capital flows. among other fundamentals, on long-term real exchange rates in Chile. The real exchange rate and its fundamentals, which can be characterized as integrated processes, are found to cointegrate in the 1960-92 period. Co integration allows a re-interpretation of uniequational estimates of the equilibrium real exchange rate (ERER) as consistent with long-run forward-looking behavioral models, It also permits the estimation of an error-correction model, capable of disentangling short-run from long-run shocks in the observed RER movements. In addition, the non-stationary nature of the fundamentals allows us to decompose innovations into permanent and transitory components. in order to get an empirical measure of sustainability of the fundamentals with which we determine the ERER.
In general the estimation of the cointegration equation of the ERER and its corresponding dynamic error-correction specification corroborates the theoretical model and produces fairly consistent results. The derived ERER index and the corresponding RER misalignment (for given sustainable values of the fundamentals) are successful in reproducing salient episodes of the recent macroeconomic history of Chile. Capital flows are disaggregated into four components: short-term capital flows, long-term capital flows, portfolio investment and direct foreign investment. As expected from economic theory, short-term capital flows and portfolio investment were found to have no influence on the ERER (though can affect the RER in the short-run). On the contrary, the other two components of capital flows have a significant effect on the ERER. The main implication of our results is that to the extent that the recent inflow of capital to Chile is dominated by long-term capital flows which are judged to be sustainable. then an important part of the ensuing RER appreciation is consistent with equilibrium behavior, thus reducing the need for counterbalancing exchange rate or macroeconomic policies.
How to Cite
Elbadawi, I., & Soto, R. (1). Capital Flows and Long-Term Equilibrium Real Exchange Rates in Chile. Economic Analysis Review, 12(1), 35-62. Retrieved from https://www.rae-ear.org/index.php/rae/article/view/135
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