Capital Controls, Exchange Rate Management and Monetary Policy in a Small Open Economy: A Stylized Model of the Chilean Case, 1978-1980

Abstract

The paper addresses in an intertemporal optimizing framework the high real interest rate and the current account deficit observed in Chile when the economy was disinflated by means of the nominal exchange rate. The particular manner the capital account was controlled (a temporary flow constraint to capital inflows) along with a passive monetary policy (the Monetary Approach to the Balance of Payments) resulted in a tight monetary policy as the balance of payments could not provide the desired money balances fast enough. When the capital account was liberalized, the observed plunge in the (medium-run) real interest rate and the sharp increase in capital inflows are consistent with the tight money hypothesis. Unlike previous literature, the high real interest rate is theoretically consistent with a current account deficit during the transition when the flow constraint to capital inflows is loose enough and the utility function satisfies some conditions. All real effects, nevertheless, can be avoided if the monetary authority provides the desired money balances through expansionary open-market operations.