Foreign Shocks and Monetary Policy Transmission in Chile

Abstract

This paper considers empirical evidence for a small open economy, characterizing and identifying the dynamic effects of foreign and monetary policy shocks on Chilean macroeconomic variables. A structural VAR approach is used with non-recursive contemporaneous restrictions. The analysis provides several interesting results. First, consistent with the predictions of a stochastic rational-expectations model, a domestic monetary contraction generates a temporary reduction of output and monetary aggregates. Second, there is no evidence of price and exchange rate puzzles. Third, the source of Chilean output, price level, and real exchange rate volatility is similar to that identified in industrial countries; monetary policy explains a relatively small fraction of output, price level, and exchange-rate variability. Finally, foreign monetary policy innovations have short-lived effects on domestic interest rates and have no major influence over other Chilean macroeconomic variables. However, risk premium shocks influence significantly both the interest rate and the exchange rate.