DF201 Exam| Question 2

#2. Why may financial liberalization policy and stabilization policy be incompatible? Discuss with respect to Chile 1973-83.

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The immediate macroeconomic effects of financial liberalization may not be favourable to external adjustment for two reasons that are commonly overlooked. First, by raising costs, higher interest rates adversely affect the supply side, especially when the corporate sector is highly indebted. Second, and more important, imperfections in domestic goods markets can produce perverse results.

Especially with regard to monopolistic powers in the market that can pass on prices in the market, thus the increase in interest rates may therefore act like a currency appreciation, and thus discouraging investment in exports and import substitutes.


"Stabilization with Liberalization: an Evaluation of Ten Years of Chile's Experiment with Free Market Policies, 1973-1983" Sebastian Edwards (PDF)

"The International Capital Market and Economic Liberalization in LDCs" Ronald McKinnon for Institute of Developing Economies


And since we started talking about this subject let me include some of the comments here:

Growth of Monetary Aggregates, Chile

Annual Inflation, Chile

Annual Inflation Rate, Chile 1985-2000

Yeah, who'd have thought a recession was in the cards?

The IMF and Chile, A Parting of Ways?
It does not seem so since after 24 years they are still members of the IMF.

In effect, the revaluation of the peso tended to generate an excess supply in the nontraded goods sector at a time when what was needed was a reduction in the excess supply already created by the decline in the rate of growth of domestic credit. In addition, the subsequent use of the exchange rate as the major stabilization tool resulted in an important real appreciation of the peso and a significant loss in the competitiveness of the domestic industries. ...the adoption of the fixed exchange rate-with inflexible real wages-in June of 1979, as the final step of stabilization process, was a serious policy mistake, which precipitated the 1982-9183 recession.