The Behavior of Interest Rates and Real Exchange Rates During a Liberalization Episode: The Case of Chile 1973-83

Abstract

This paper analyzes the behavior of some key variables during the recent economic liberalization reform attempted in Chile. The paper concentrates on the behavior of the real exchange rate and nominal and real interest rates during the period 1977-83. It is argued that as a consequence of the liberalization of the capital account in Chile in 1979-81, dramatic inflows of financial capital resulted. These capital inflows generated an important increase in expenditure, and a lower relative price of tradables to nontradables or real appreciation. Moreover, it is argued that it is the liberalization of the capital account, and not the adoption of a preannounced rate of devaluation, that generated the dramatic real appreciation of the Chilean currency between 1979 and 1981 . A model to analyze interest rate behavior in a semi-open economy is also presented and applied to the case of Chile. The results obtained suggest that during this period interest rates responded both to open-economy and closed-economy factors. Among the former the increase in the expected rate of devaluation was particularly important.