Exchange Rate, Real Adjustment

and Monetary Policy

José De Gregorio
Governor
Central Bank of Chile

CENTRAL BANK OF CHILE AUGUST 2009

 Motivation

Full fledge IT regime in place in Chile since 1999.

Exchange rate is important because:

Can affect relevant relative prices so to induce resources

reallocation (expenditure-switching)

It has implications over inflation (determined by the size of

pass-through)

How can monetary policy affect those mechanisms? What

are the effects of increase credibility?

2
 Real Exchange Rate, Volatility and the Persistence
of Misalignments

Real Exchange Rate

(index, 1986=100)

120 120

110 110

100 100

90 90

80 80

70 70
90 92 94 96 98 00 02 04 06 08
Source: Central Bank of Chile.

3
 Outline

1. Inflationary effects of exchange rates and

expenditure-switching

2. Volatility and misalignments

3. Misalignments and monetary policy

4
 Exchange rate pass-through to CPI has declined
substantially since 1999

Pass-
Pass-through to CPI
(10-year rolling regression)
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0.0 0.0
-0.1 -0.1
-0.2 -0.2
-0.3 -0.3
98 99 00 01 02 03 04 05 06 07 08

Source: Author’s calculations.

5
 In Chile, nominal devaluations have a negative impact
on terms of trade

Correlation Between Nominal Devaluation and Terms of Trade Variation

Variation 1/
(quarterly data)
Correlation t-test
1990-2009 0.35 3.28
1990-1999 0.38 2.50
2000-2009 0.47 3.18
1/
As in Obstfeld and Rogoff (2000) a positive correlation indicates that a nominal
devaluation has a negative impact on terms of trade, which are defined as the relative
price of imports with respect to exports.
Source: Author`s calculation

Despite the declining pass-through, relevant relative prices adjusts.

Movements in nominal exchange rate can induce the expenditure
switching.

No evidence of LPC hypothesis.

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 Exchange rate pass-through to tradable CPI has
remained rather stable since 1999

Pass-
Pass-through to Core Tradable CPI
(10-year rolling regression)
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0.0 0.0
-0.1 -0.1
-0.2 -0.2
-0.3 -0.3
-0.4 -0.4
98 99 00 01 02 03 04 05 06 07 08

Source: Author’s calculations.

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 Pass-through to total CPI has declined more than
to tradable CPI

Difference Between the Pass-

Pass-Through to Core Tradable and Total CPI
(percentage points)

0.3 0.3

0.2 0.2

0.1 0.1

0.0 0.0

-0.1 -0.1

-0.2 -0.2
98 99 00 01 02 03 04 05 06 07 08

Source: Author’s calculations.

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 Pass-through to Wholesale Import Prices has
increased.

Pass-
Pass-through to Wholesale Import Price
(10-year rolling regression)
0.8 0.8

0.7 0.7

0.6 0.6

0.5 0.5

0.4 0.4

0.3 0.3

0.2 0.2

0.1 0.1

0.0 0.0
98 99 00 01 02 03 04 05 06 07 08

Source: Author’s calculations.

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 Determinants of Pass-through

Determinants of Nominal Exchange Rate Depreciation to Inflation Ratio 1/

(sample 1989.Q2-2009.Q1)

Coefficient Std. Error t-Statistic

C -0.30 0.89 -0.34
q (-1) -0.07 0.07 -1.06
cc (-1) -0.86 0.40 -2.15
ygap (-1) -0.68 0.24 -2.79
Adj. R-squared 0.35
1/
The dependent variable corresponds to the exchange rate depreciation in period t
divided by inflation in the same period. The explanatory variable corresponds to real
exchange rate misalignment (q):; current account to GDP (cc ) and the output gap
(ygap). Quarterly estimation.
Source: Author`s calculation

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 Derivatives in Chile

Exchange Rate Derivatives in Chile

(December of each year; as a percentage of)

6 6

5 5

4 4

3 3

2 2

1 1

0 0
95 96 97 98 99 00 01 02 03 04 05 06 07 08

GDP Total Trade

Source: Central Bank of Chile.
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 Exchange rate misalignment less persistent
since 2000.

Duration of Real Exchange Rate Misalignment

Duration real exchange rate

Error correction coefficient misalignment (quarters)
1977-2007 -0.12 8.1
1977-1999 -0.11 9.0
2000-2007 -0.31 3.2
Based on Caputo, Nuñez and Valdés (2008)

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 Misalignments and monetary policy

• Exchange rate affects monetary policy through its

effects on inflation. Lean against the wind

• How to deal with significant deviations from

fundamentals?

• How to deal with bubbles on domestic assets?

Tightening monetary policy may exacerbate the
bubble. Intervention is an option.

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Exchange Rate, Real Adjustment
and Monetary Policy

José De Gregorio
Governor
Central Bank of Chile

CENTRAL BANK OF CHILE AUGUST 2009