metadata: authors: 0: author: Solimano,Andres R.
count: Chile
docna: 0: docna: Macroeconomic constraints for medium term
            growth and distribution : a model for Chile
docty: Policy Research Working Paper
subtopic: Public Sector Economics,International Trade and Trade Rules,Inflation,Macroeconomic Management,Public Financial Management,Public Finance Decentralization and
            Poverty Reduction,Inequality
teratopic: Environment,Macroeconomics and Economic Growth,Finance and Financial Sector Development,Poverty Reduction
abstracts: cdata!: The recovery of the Chilean economy
            since the mid 1980s, has certainly been successful in
            macroeconomic terms. In fact, the restoration of growth and
            the correction of external imbalances after the severe
            economic crises of 1982 -83 has taken place in a
            macroeconomic environment of moderate inflation, without
            major fiscal imbalances, exports have expanded significantly
            and foreign debt burden indicators have improved. However,
            distributive and poverty related indicators point to pending
            problems. The major challenge, therefore, is to maintain
            sustainable rates of economic growth, address the social
            issues of poverty reduction and improve income distribution
            patterns, while preserving macroeconomic and financial
            stability. The paper is organized as follows : Section I is
            an introduction. Section II presents a formal macroeconomic
            model that identifies major constraints ( external, savings
            and fiscal ) that shape the scope for growth. In Section III
            the model is numerically calibrated with parameters of the
            economy and three policy exercises are explored : i) an
            increase in public spending; ii) a reduction of interest
            payments of 3 of potential GDP; and iii) a reduction of the
            markup rate of 4. Section IV reviews various policy
            excercises and the conclusions are summarized in Section V.
geo_reg_key: 517191,119228
repnme: repnme: Macroeconomic constraints for medium term
            growth and distribution : a model for Chile
display_title: Macroeconomic constraints for medium
            term growth and distribution : a model for Chile
listing_relative_url: /research/1990/04/700304/macroeconomic-constraints-medium-term-growth-distribution-model-chile
topicv3: Public Finance Management m1326316 716,Poverty m1326687 695,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Balance of Payments m1326965 441
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment,Macroeconomics and Economic Growth,Finance and Financial Sector Development,Poverty Reduction
origu: Policy, Research & Ect Affairs
no_of_pages: 48
author_keys: 0: author_key: 141932
model_extractions: <!-- Start of picture text --> Policy, Research, Pnd External Affaiis<br><!-- End of picture text -->

**Macroeconomic Adjustment and Growth**

- This paper a product of the Macroeconomic Adjustment and Growth Division, Country Econoioics Department -- is part of a larger effor' in PRE to develop applied macroeconomic models to support the design of adjustment programs. Copics arc available free from the World Bank, 1818 H1 Street NW, Washington DC 20433. Pleasc contact Emily Khine, room Nl 1-062, extension 39361 (43 pagCs with figures and tablcs).

Solimano uses this model to examine policies geared to reducing poverty' and improving income distribution **pattern.s** in terms of their macroeconomic impact on the Clhilean economy. Hc concludes that in a capacity-constrained environment:

* An unbalanced increase in government spending (in the social sectors) of 3 percent of potential GDP will slow down thc rate of GDP growth **by 1** percent.

* Rcducing interest paymcnis abroad by 3 percent of GDP would accelcraitc thc rate of GDP growth by 1.7 perceint, reduce thc rea! exchange rate by 8. 1 percent, and increase rcal wages 6.6 perceint.

* A cut in the mark-up rate of 4 percent would increase both external competitivencss

and real wages, allow ng the rate of capacity utilization to increase 1.4 percent. InfiTtion would be reduced 4 oercerit on impact.

> * The balance of payments and fiscal hudgct can be considered binding if a turnaround in copper prices takes place, as mani obscrvcrs predict.

> * The lcvel of productivc capalcity seemlis to be a main macrocconomilic constralint lor expansionary demand policies, at least in thc short to mcdium run. An incre.sc in savings and investnient is crucial to sustained gmwwth.

> * Infnation is currentlv moderately low in Chile, but as the cconomy hovers around flull capacity utilization and grovvth rema:ins high. inflationary pressurcs may be mounting.

The PRE Working Paper Serics disseminates the findings of work under way in the Bank's Policy. Research, and External Affairs Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and cenclusions in these papers do not necessarily represent official Bank policy.

lrocduced at the PRE Dissemination Center
# TABLE OF CONTENTS

1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . 1 2. A Simple Macroeconomic Model with Growth . . . . . . . . . . 6 3. A Numerical Calibration of the Model fcr Chile . . . . . . . 23 4. Policy Exercises.. ............. 26 5. Conclusions . . . . . . . . . . . . . 34

This paper was presented in the UNU/WIDER Conference on "Medium-term Development Strategiesw held in Oslo, Norway on Cctober 12-14, 1989. Comments made by Bela Balassa, Andrts Gomez Lobo and Lance Taylor are acknowledged.
# 2. Introduction

The recovery of the Chilean economy since the mid eighties, has certainly been successful in macroeconomic terms. In fact, the restoration of growth and the correction of external imbalances after the severe economic crises of l9R2-1983 has taken place in a macroeconomic environment of moderate lnflation, without major fiscal imbalances, exports have expanded significantly and foreign debt burden indicators have improved. However, distributive and poverty related indica..ors show this is an area of pending problems. The share of the population under the povezty line is quite sizeable, Torche (1987); a finding also supported in other studies, Rodriguez (1985) and Pollack-Uthoff (1986). The real minimum wages and other low skilled workers wages (like construction) have deteriorated significantly even though the observed reduction in unemployment has ameliorated these effects on total lcbor i'ncome. Therefore, it appears as a major challenge to maintain sustainable rates of economic growth, address the social issues of reducing poverty and improving income distribution patterns, while preserving macroeconomic and financial stability. The purpose of this paper is tc examine analytically what are the main macroeconomic constraints to achieve those goals in the Chilean economy. _Th_ e **paper** is organized as follows. In section 2 we present a formal macroeconomic model that identifies the major constraints (external, savings and fiscal) that shape the scope for growth.
_-2-_ The model, in Zurn, introduces the distinction between demand constrained, capacity constrained and in.lationary growth regimes under which different macroeconomic policies may have distinct effects on growth and distribution.

In Section 3 the model , numerically calibrated with parameters of the Chilean economy. This procedure allow us to parameterize the foreign, savings and fiscal constraints, or gaps, and to quantify the major trade-offs. Then three policy exercises, or shocks, are explored with the model: i) an increase in public spending (in social sectors) of 3Z of potential GDP; ii) A reduction of interest payments abroad of 32 of potential GDP; and iii) P reduction in the mark-up rate of 42. Those policies are carried out under different growth regimes (more emphasis is given to the capacity constrained-growth regime in order to reflect the limits imposed by existing productive capacities on the possibilities of pursuing expansionary demand policies).

Moreover, these policies are evaluated in terms of their impact on the rate of GDP growth, the rate of capacity utilization, the real exchange rate, real wages, and the rate of inflation. Finally, the paper concludes in Section 5.
- 3 -

# **Table 1**

# Chile: Macroeconoaic Indicators

|(|GDP<br>growth rate)<br>Z|capacity<br>utilization<br>(index )|Investment<br> <br>rate<br>(Z of GDP)|<br>Current<br>Account<br>(Z of GDP)|rate of<br>inflation<br> <br>( Z)|Public<br> <br>Savings<br>(Z of GDP)|
|---|---|---|---|---|---|---|
|1981|5.7|100.0|19.5|-<br>14.5|9.5||
|1982|-<br>14.7|77.6|15.0|-<br>9.5|20.7|- 0.9|
|1983|-<br>0.8|74.9|12.9|-<br>5.7|23.1|0.0|
|1984|6.3|81.8|13.2|-<br>10.7|23.0|0.5|
|1985|2.4|83.4|14.8|- 8.3|26.4|3.7|
|1986|5.7|87.6|15.0|-<br>6.5|17.4|4.6|
|1987|5.5|91.4|16.5|-<br>4.8|21.1|5.3|
|168O|7.4|,5.7|17.0|-<br>o07|12.7|5.6|

Source: Chilean National Accounts and Balance o. Payments Statistics Central Bank of Chile (1988). The index of capacity utilization draws from Marfan and Artiagoitia (1989).
-4-

**Table 2**

**Chile: Distributive and Social Indicators**

||Real Wage;<br>(index)|Real Minimum Wages<br>(index)<br>percentages|<br>Unem<br>(1)|ploymen<br>(2)|t<br>rate<br>|Gini<br>Real<br>coeff. Wages<br>constr.|
|---|---|---|---|---|---|---|
|1981|100.0|100.0|10.4|15.1|52|<br>100.0|
|1982|99.9|101.0|19.6|26.1|54|<br>94.9|
|1983|89.0|81.0|18.7|31.4|54|<br>71.0|
|1984|89.0|70.0|15.9|24.0|55|<br>61.4|
|1985|8Z,^0|66.0|16.0|24.2||51.5|
|1986|87.0|64.0|13.9|19.1||47.8|
|1987|87.0|60.0|12.6|15.8||46.9|
|1988|9 .0|63.0|10.2||||

Source Cepal (1989), Arellano (1988), Larrain (1989), Solimano (1988) (.) open unemployment rate. (2) open urnemployment rate plus emergency employment programs.

TRbles 1 and 2 suggest some important features of the cur:ent macroeconomic and social situation that may be important for shaping the growth possibilities of the Chilean Economy.

:.) After five years in which the Chilean economy has been growing at an average rate of 5.5Z per year, (1984 -1988), with a fairly low investment rate (15.2Z of GDP on average), the question arises on the feasibility of sustaining those rates of growth over the medium term without a major increase in investment. In particular when the margins of unused capacity are narrow **as it** seems to be the case by the late eighties (see the second column in Table 1, and
- 5 -

consider that the **rate** of grovth of **GDP** for 1989 is estimated in about 10 percent).

ii) Concerni , the sources of savings to finance the investment effort, it is appa7ent from looking at Table 1 that the contribution of foreign savings has been steadily declining since the crises . 1982-83. Moreover, R major reversal of this trend is unlikely given the current credit constraints in international capital markets. On the other hand, the share of public savings has been increasing in the same period, in an attempt to compersate the fall in the foreign savings share.

iii) Inflation in Chile has been moderately low during the adjustment process (it averaged 192 per year between 1981-8a). At least if compared to other Latin American economies in the same period. In addition, in 1988 inflation was near to the one digit level. However, as the economy approaches a high rate of capacity utilization and current growth is high, inflationary pressures may be mounting. Hence these pressures could also be considered as a potential macroeconomic constraint for high growth, at least if we are interested in maintaining inflation at moderate levels.

iv) The distributive and social indicators worsened significantly during the adjustment process, although the situation have improved since 1983 . rherefore, a demand for action in this field certainly exist. Thz :oom for social policies and distributive moves is conditioned, to a great extent, by how tight (or relaxed) the external, caving and capacity constraints are and by the state oL the public finances. In particular, as mentioned before, the absence of excess capacity in the aggregate reduces the room for a policy of increases in real wages, likely to have an expansionary impact in a demand constrained situation (see Solimano 1988). On the other hand, the external constraint and
- 6 -

the need to generate sizeable trade surpluses for foreign debt servicing also poses ceilings on the wage policy that are import&nt to bear in m;nd.

The fiscal situatio.. is currently in good shape to accommodate increases in government spending with a social content; however, different fiscal instruments should be used to maintain (or even increase) the cvirrent levels of public savings since they constitute an important source of financing public and aggregate investment.

In the next section, we specify the macro model that will permit us to quantify the growth constraints and the impact of different policies.

# 2. A Simple Macroeconomic Model with Growth

In this section we shall specify a simple macroeconomic model that explicitly incorporates growth into the analysis. The model is a blend of a three-gap model (besides the traditional savings and foreign gap a fiscal gap is now introduced as a -potentially-additional constraint to growth, see Bacha, 1989 and Taylor, 1988) with a disequilibrium model (Solimano, 1988) extended to deal explicitly with capital formation and growth. A departure from Bacha - Taylor is that some key relative prices like the real wage and the real exchange rate are not fixed but are allowed to change.

The analysis distinguishes between different 'growth-regimes," where the regimes are classified as demand constrained, capacity constrained and inflationary growth regimes. Every regime, in turn, describes the macroeconomic environment in which the growth process takes place. Analytically this may prove to be a useful way to link the short and the meditum run and it is also intended to show how different policies can affect the rate of growth in
-7-

distinct ways, depending upon the dominant regime in th" cconomy.

The model first identifies which are the maisi macroeconomic constraints to growth following the traditio.aal distinction between the external constrpkint (or foreign gap), che savings constLaint (or internal gap) and the novel fiscal constraint whose meaning will be discussed later.

The next step is to provile a behavioral content to the main equations -if the model. Then, we specify which variables endogenously adjust to bring macro equilibrium and which variables are taken as exogenously determined The closure rule adopted is what defines the growth-regime.

Let us start, first, with the national accounts identity between investment and savings.

where: Y is output (GDP), C is private consumption, T is cuirrent revenues of the government, G is government consumption, M represents total imports, X are total exports and I is gross investment.

Tntroducing net factor payments abroad, R* , (which includes interest payments on foreign debt) and assuming that a share q of the debt is owed by the private sector and a share l-q by the government, 0 < q < 1, equation (1) can be written as :

- Redefining terms, Sp is national savings equal to Y -C qR*. Sg is public savings equals to T -G -(l-q)R* and Sf is foreign savings, namely the deficit in the current account, H - X + R*. Therefore,
# (3)

Equation (3) is the saving constraint. Investment, as a share of potential GDP, i-I/y , is related to the rate of potential GDP growth, g - _5y/y._ through the following equation

# (4)

where k is an incremental output-capital ratio and go is a term reflecting labor-productivity growth and the effects of su'ply shocks.

Private national savings, is mXde a fLaction of disposable national income YD - Y(l-t) - qR*. Expressing the savi:-g function, (relative to potential GDP) sp-Sp/y, as a linear function of national disposable income.

where u- Y/y is the level of capacity utilization and t is the average direct tax rate and q r* is the part of interest payments abroad served by the private sector, as a share of potential GDP.

Public saving, in turn, can be decomposed as Sg - (taxes + net surplus of public enterprises + net transfers) - (current consumption + interest payments on public debt). Public savings as a ratio of potential output, sg a _Sg/y_ , shall be made a linear function of the level of capacity utilization. Tax revenues and operational profits of puolic enterprises are assumed to rise with u.
a bo+ blu (6) Foreign saving, the current account deficit (in dollars),<sup>sf, asa</sup> ratio of potential output, may be written as the<sup>sum of imports of capital</sup> goods, **mk.** imports of lntermediate goods, mz, and imports<sup>of consumption goods,</sup> mc minus total exports, x, plus net factor payments abroad,<sup>r *</sup> **(All** lowercase variables, ire expressed as ratios of potential<sup>GDP).</sup> Imports of capital goods, is written as a function<sup>of the rate of</sup> grovth of potential GDP, g, and the real exchange<sup>rate (perhaps with a low</sup> elasticity in the short zun, in the case of capital goods<sup>not produced at 'aome),</sup> dafined as er = e p*/p , where e is the nominal exchange rate,<sup>p* is</sup> international prices and p is the price of domestic goods.

# (8;

Imports of intermediate goods, normalized by y, are made a function of the real exchange rate and the level of capacity utilization

# (9)

Adopting a similar specification, for the imports of consumption goods,
- 10 -

# (10)

Total exports, in turn, will be a positive function of the real exchange rate, er, and the level of world demand, Y*.

(11) The balance of payments knormalized by potential output) may be written as B/y - F/y - s f where B represents international rererve accumulation, F denotes net capital inflows and s f was defined as the (normalized) current accouit deficit, all in dollar terms. Plugging equations (8), (9), (10), (11) and (7) into the balance of payments definition we obtain the foreign

**exchange constraint:**

Equation (12) represents the constraint imposed by the balance of payments on the level of economic activity and the rate of growth of GDP when the availability of foreign exchange is a binding restriction in the system. In turn, the coefficients in "12) correspond to co = fo + ho + io - Vo cl- f2 + h, +ij - **v1** , c2 - h2 + J2 , c3 -fl and c4 - v2 As the current account, s f, is denominated in dollar terms, the sign of the coefficient cl, denoting the impact of a real depreciation on the current account deficit, is non-positive. (i.e., cl < 0 ). Namely a real depreciation will improve (or at least not deteriorate) the dollar value of the current
- 11 -

account of the balance of payments. The current account in (domestic currency) could deteriorate after a real devaluation if the deficit is initially large or the trade elasticities are too low.

In order to focus on the constraints to growth, we shall solve equation (12) for the rate of growth of potential GDP.

gf is the maximum rate of growth of potential GDP that a foreign exchange constrained economy could afford in order to satisfy the restriction imposed by the balance of payments. In this setting, an increase in interest payments abroad, a rise in r *, shall reduce growth because of the lower availability of foreign exchange to finance imports of capital goods. A real depreciation, i.e<sup>6</sup> er > 0 , allows to accelerate the rate of growth of GDP since it provides extra foreign exchange through increasing net (of capital goods) exports. Conversely an increase in the level of capacity utilization, i.e., as a consequence of following expansionary demand policies, will tend to increase the imports of current goods, for a given level of net foreign financing and exports, that amounts to a cut in imports of capital goods and growth. i.e., 6gf/6u < 0 .

The saving constraint, in turn, includes foreign savings in domestic currency. Normalized by the level of potential output, the equation for foreign - - saving in domestic currency, sf Sf/y, may be written as
- 12 -

where wo picks up the intercepts of equations (8)-(11), included the term representing net factor payments abroad in domestic currency relative to potential GDP , r*-R*/y. The coefficient w1 will be assumed to take a value less than zero, w1 c 0 , namely a real depreciation of the exchange rate will reduce the current account deficit in domestic currency. Furthermore w2 >0 and w3 >0, w 4 <0 The condition savings equals investment, or saving gap, given by - equation (3), normalized by the level of potential output, can be written as Combining equations (4), (5) , (6) and (14) and plugging them into equation (15) gives rise to the **saving** constraint expressed in terms of the rate of growth of potential output.

where g5 13 the maximum rate of growth of potential GDP consistent with the saving constraint. In turn, do - go/k + ao + bo + wo -alqr* , d, - w, < 0 and d2 - a1(l-t) + bl + w2 > 0.

A stability condition is that kw3 <l From our previous assumption that _w,_ c 0, a real devaluation will reduce growth if the savings constraint is binding and output is at full capacity, say u -1. This result is due to the reduction in foreign savings following the real devaluation not compensated with an increase in domestic savings. Looking at it from the demand side, given Y-y
- 13 -

(full capacity utilization), an increase in net exports following a real depreciation has to be accommodated through a reduction in investment that slow. growth. Conversely, if output or the rate of capacity utilization are allowed to vary, in a keynesian fashion, a real devaluation that increases net exports and output, will not necessarily crowd-out investment and slow growth since domestic saving will rise along with u Up to this point we have stated the foreign exchange and the savings constraints, let us turn now to the **fiscal constraint.** This constraint intends to reflect the impact of the availability of fiscal resources to finance public investment required to support a given rate of GDP growth.

Another dimension of fiscal de.icit lies in its effects on macroeconomic stability in particular on inflation and the balance of payments. In this perspective, the fiscal constraint may be interpreted as a "constraint of macroeconomic stability,' considering a stable macro environment as a requisite for sustainable growth.

A useful way to write the fiscal constraint is in terms of Public Sector Borrowing Requirements, PSBR, since it includes public investment and then it can be linked to the GDP growth rate. Using lowercase notation to denote variables normalized by the level of potential output: where psbr -PSBR/y is the ratio of public sector borrowing requirements and potential GDP; in turn, ig-Ig/y is the ratio of public investment to potential - GDP and sg Sg/y represents public sector savings as was previously defined.

To solve the fiscal constraint in terms of the rate of growth of
- 14 -

potential GDP let decompose total investment, relative to potential GDP, i into the **sum** of private investment, ip, and public investment, ig.

Now, making private investment a function of the level of public investment and the level of capacity utilization.

The sign of the coefficient a shall depend on whether public investment crowds-in or crowds-out private investment. Typically, in LDC's, government investment in infrastructure like roads, ports and the like is expected to be complementary with private investment. On the other hand, some public investment may be competitive with private investment. If the former effect is dominant a is positive, conversely if crowding-out effects were dominant a would turn negative. The parameter B is expected to be positive, since an increase in the rate of capacity utilization (an indicator of demand conditions in the economy) will have a stimulative effect on private investment.

- Now, replacing (19) in (18) we can write

Inserting equation (20) in (4) and solving for ig yields
- 15 _

- Replacing equation (,1) in (17) and solving for g we obtain

(22) gg k(l+a) ( psbr +bo + (g0/k + _i0)/l+a_ + (b1 +3/1+a) u I where g8 is the maximum rate of potential GDP growth consistent with the fiscal constraint defined in terms of a certain (psbr) public sector borrowing requirement target. In this context a relaxation of the fiscal constraint, e.g., the psbr coefficient increase, channeled towards an increase in public investment will increase the rate of GDP growth (we are assuming that 1+ a > 0). Another result is that increases in u, the rate of capacity utilization, shall accelerate gg, since npt revenues and therefore public savings increase then providing more resources to finance higher public investment and support more growth.

- The price level in the model is given by

> where 'r is the (constant) mark up rate, p is the labor -output coefficient w is the nominal wage rate, 0 is the foreign input component of a unit of output and ep* is the domestic currency price of foreign inputs.

Dividing both sides of equation (23) by p and solving for wlp we obtain a monotonic inverse relationship between the real wage and the real exchange rate given the mark-up rate and the technical input-output coefficients.
16 -

-

Suamrizing, the model can be reduced to five equations:<sup>the foreign</sup> exchange constraint equation (13), the savings constraint<sup>equation (16), the</sup> fiscal constraint represented by equation (22),<sup>equation (24) is the</sup> relationship between the real wage **and** the real exchange rate. The inflation sector of the model is presented below, equations<sup>(26) and (27) and is</sup> represented ir semi-reduced form by equation ,28). These equations, in turn, are solved for the rate of growth of GDP, g , the level of<sup>capacity utilization,</sup> u , the real exshange rate, ep*/p , the real wage,<sup>w/p,and the inflation</sup> rate, **i.** Let us turn now to the three regimes defined<sup>in the model: the first</sup> one is a fix price -excess capacity regime where w,<sup>p, e are fixed (</sup><sup>**_i_**-0 )</sup> and the system is solved for g and u. This regime will<sup>be labeled as a demand</sup> constrained-growth regism, where growth takes place in an economy operating<sup>with</sup> excess capacity. One way to solve the system in this regime<sup>would be through</sup> the min. condition, for a given u.

- (25) g min {gf, gs gg)

Another way to solve the system in the demand constrained<sup>regime is to</sup> obtain simultaneously a solution for g and u assuming fix the real wage,<sup>;he</sup> real exchange rate and the price level. This retains<sup>the fix price spirit of</sup> the disequilibrium models where, in a Keynesian<sup>fashion, quantities adjust</sup> (included now the rate of potential GDP growth).

The second regime represents the case of an economy<sup>operating at full</sup> - capacity u 1, where wages and prices are flexible (e<sup>is fixed or</sup> predetermined by the exchange rate system). This situation corresponds to the
- 17 -

**capacity coastraiued-growth regime** where the growth process takes place in an economy operating **at** full capacity. In a model with different savings propensities between labor and capital, full capacity utilization and nominal wages adjusting slower than prices, this would correspond to a forced savings **regmUe** where changes in income distribution towards high savings groups is the adjusting mechanism to assure full capacity, see Taylor (1988).

- A third regime we explore is an inflationary grovth regime in which growth occurs in a macro setting characterized by inflation and disequilibrium (or slow adjustment) in the goods market a la Phillips curve. Inflation, in this open economy, is a weighted average between the rate of growth of nominal wages and the rate of growth of the domestic price of imported inputs (the rate of devaluation plus foreign inflation). Formally, differentiating equation (24) **and** assuming a constant mark up rate, yields:

# (26) _- a_ * + **(l-)(a +g*)**

where r - Up/p , w _-6w/w_ , e-6e/e and X -6p*/p* . In turn, the parameter d denotes the share of labor in unitary costs and 1-0 is the share of intermediate inputs.

The wage equation in rate of growth form i- endogenous in the model and depends on cu:rent inflation and the degree of excess demand (or supply) in the goods market.

(27) _-_ o **_Uf_** - e(l-u) where o is a wage indexation coefficient and **e** measures the sensitivity of nominal wages growth to degree of slack or excess demand in the goods market,
- 18 -

measured through deviations of current capacity utilization<sup>from full capacity</sup> use (u-i). Plugging equation (27) into (26)<sup>we arrive to the fo-1,ding</sup> expression for the rate of inflation: In general this regime may be consistent both with<sup>a demand constrained or</sup> a capacity constrained situation in the goods<sup>market. Figure 1 to 3 show the</sup> graphical solution of the model for each growth-regime<sup>and the comparative</sup> static is developed in next section with an<sup>empirical application to Chile.</sup> <!-- Start of picture text --> Figure ls Demand constrained - growth reainm<br><!-- End of picture text --> <!-- Start of picture text --> £ F<br>growth S<br>rate<br>G<br>G<br><!-- End of picture text --> capacity utilization, u The downward sloping FF s hedule represents<sup>the external constraint,</sup> equation (13), in the space (g,u) for given<sup>values of the real exchange rate</sup> and interest payments abroad. It is<sup>negatively sloped since an increase in u</sup>
- 19 -

raises current goods imports, reducing<sup>the resources available to import</sup> capital goods hence forcing to cut-down<sup>growth, 6g,/6u < 0. The SS schedule</sup> representing the saving gap, equation (16), is<sup>upward sloping since an increase</sup> in u rises domestic savings generating<sup>more resources to invest, 5gs/6u>0</sup> The GG schedule is the fiscal<sup>constraint, equation (22), is also</sup> positively sloped since an increase<sup>in the rate of capacity utilization</sup> increases net revenues of the government,<sup>thus producing more resources to</sup> finance a higher level of public<sup>investment that could support more rapid</sup> growth. On the other hand, the schedule<sup>is assumed to be flatter than the SS</sup> schedule.

The equilibrium solution for g and<sup>u arises from the intersection</sup> of the three schedules SS, FF and GG. In<sup>case these lines do not intersect at the</sup> same point, some assumption is needed<sup>with respect to which gap is not binding</sup> in the system in order to avoid an<sup>overdetermined</sup> system.
- 20 -

<!-- Start of picture text --> Figure 2. Capacit, constrained-growth reCete<br>growth<br>rate<br>G<br>real exchazge rateep *Ip<br>real<br>vage,vlP<br><!-- End of picture text --> Figure 2 represents the capacity constrained-growth regime in the - space g and er (in this regime capacity utilization is fixed, u 1). The FF schedule is positively sloped now, reflecting the positive effect of a real depreciation on the availability of foreign exchange that allows to finance a higher level of capital goods imports and support more rapid growth. The SS schedule is negatively sloped since a real depreciation is assumed to reduce the deficit in the current accosnt, cutting foreign savings. Then a lower level of - investment (and growth) is required to maintain savings investment. Finally, the GG schedule is an horizontal line, independent of er.
- 21 -

In the bottom part of Figure 2 we draw the relationship, in levei form, between real wages and the real exchange rate, equation<sup>(24). The relatiouship</sup> is negative e.g., a real depreciation implies a cut in real wages, as far as the mark-up and the input-output coefficients in the price equation remain fix. An improvement in productivity or a reduction in the mark-up<sup>would allow a real</sup> depreciation of the exchange rate - a gain in external<sup>competitiveness</sup> - that need not to be accompanied by a squeeze in real wages.
<!-- Start of picture text -->
- 22  -<br>Figuro  3.  Inflationar,-arowth  resime<br>growth  rate<br>capacity utilization,u<br>rate  of<br>inflation<br><!-- End of picture text -->

Figure 3 represents the inflationary-growth regime. The upper part of this figure correspcnds to the demand constrained regime and the bottom part displays the relationship between the rate of inflation and the rate of capacity utilization, equation (28), given a rate of devaluation and foreign inflation. The siope of the schedule gets steeper (worsening the trade-off between inflation and the level of capacity utilization) as the economy approaches full capacity utilization, wage growth respond more to and increase in u and/or the degree of wage indexation increases in the economy.
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3. A Numerical Calibration of the Model for Chile In this section the model specified in the previous section<sup>is</sup> calibrated. The calibration procedure uses coefficients<sup>fro.ia</sup> three sources: i)econometric estimates of some key functions (like import and export 3quations, investment equationb,price equations, ii) values calculated divectly<sup>from time</sup> series or iii) assumed plausible coefficient values. To assure consistency to the base year values coming from National Ac .ounts and Balance of<sup>Payments</sup> Statistics (that base year is 1987) the constant terms of the model's equations are adjusted so as to replicate that year. The appendix documents the<sup>initial</sup> values of the variables of the model and some parameters used to estimate<sup>the</sup> growth constraints and other relationships of the model.

Let us turn now to the parameterization of the model. Taking 1981 as a year of "full" capacity utilization for the Chilean economy and assuming<sup>an</sup> annutal rate of growth of capacity output of 1.5? we obtain a rate of capacity utilization for 1987 of 0.946 (a little bit higher than the estimated for that year in Marf4n and Artiagotia, 1989). The output-capital ratio , k , is .333 so the implied ICOR is 3.0. The accelerator coefficient in the investment function, B, is 0.059 and the crowding-in parameter, a, is - 0.23 (Zucker, 1988). The parameterization of the private sector savings rate function is 9pn - 0.087 + 0.16 u , for the public savings rate is sg- - 0.046 + 0.1 u (note that negative intercepts imply marginal savings rates for private<sup>savings</sup> and public sector net revenues -hat exceed averages propensities). The<sup>foreign</sup> savings rate function, in domestic currency, is Sf - 0.136 **+** 0.34 er + 0.645 i + 0.487 u - 0.314 Y*. These equations show (recall the model is stated in terms of shares) that a 1? increase in the rate
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of capacity utilization increases private savings by 0.16? and public savings by 0J2 (a flatter GG schedule than the SS locus in the g,u space, Figure 1).

The foreign savings equation, .n turn, shows that a real depreciation of 10? shall reduce the current account deficit by 3.4?. On the other hand, a 1S increase in the capacity utilization ratio will increase the current account deficit in 0.645Z. Combining these equations (private, public and foreign savings rates) we obtain the savings constraint. Solving for the rate of growth of GDP yields gs - 0.010 - J.318 er + 0.699 u - 0.294 Y*, In terms of the Figure 1 notice that a real depreciation shife.s downward the SS schedule. Given u this means that a real devaluation of the exchange rate reduces growth when the savings gap is binding. Turning to the foreign gap, or balance of payments constraint, the parameterized equation is gf - - 0.064 + 0.198 er - 0.251 u +0.161 Y* it is downward sloping in the space g,u but the terms of the tradeoff between capacity utilization and growth seem to be not too severe (-0.251) along the foreign exchange gap. A real depreciation, in turn, shifts upward the FF schedule allowing a higher rate of GDP growth given u. Which effect dominates? It is clear that the downward shift of the SS schedule following a raal devaluation is larger than the upward shift in FF (-0.318 versus + 0.198). This is an important result since it suggest that a real depreciation reduces growth in the demand constrained-growth regime given the parameters values used for Chile. In this respect, the mirror image of a real devaluation, namely a **cut in real vages, would decelerate** growth (but increase capacity utilization) in the case the saving gap shift is dominating, see Figure 4. However, if the
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economy were foreign exchange constrained, in the sense<sup>that the upward shift</sup> in FF dominates, the opposite result for the rate of growth of<sup>potential GDP</sup> will be obtalned; namely a cut **ln real waget**<sup>would accelerate growth).</sup> Therefore, a demand constrained-growth regime is consistent both with an accelerationist or stagnationist response of growth to a cut in<sup>real wages.</sup> The final result will depend on the specific parameters<sup>values that make the</sup> saving gap or the foreign gap effect to dominate following<sup>a cut in real wages.</sup> Turning to the parameterization of the fiscal constraint we get 88- 0.010 + 0.049 u. Then, it is apparent that the<sup>trade-in coefficient</sup> between u and g along the fiscal gap iY quite small.

The inflation equation is parameterized as r - 0.55 w + 0.45 (e + 5*), where the mark-up rate as well as the input-output coefficients are assumed to be constant. From this equation the relationship between real wages and the real exchange rate, in log-change form, is * -<sup>r-</sup> - 0.81 (a + r* -X). Then a real devaluation of 102 will reduce real wages<sup>by 8.1? holding the mark-up</sup> and the input-output coefficients as fixed.

The wage equation is 9 - 0.7 r + 0.25 (1-u). This assumes an indexation coefficient of 0.7 for nominal wages<sup>and a coefficient of response</sup> of nominal wages to the output gap of 0.25. Combining<sup>the structural equation</sup> if inflation with the wage equation we get the following semi-reduced<sup>equation</sup> for the rate of inflation i - 0.223 (u -1) + 0.731 (a + Xr ). It is interesting to note that the sensitivity of inflation<sup>to the output gap is</sup> rather moderate (0.223). However, we can<sup>expect that the effect of an increase</sup> in capacity utilization on inflation depends<sup>also on how close the economy is</sup> to full capacity, mainly trough an increase in<sup>the response of nominal wages</sup> growth to **a** higher rate of capacity utilization in the<sup>goods market. In fact,</sup>
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that parameter could be specified as a positive function of u, say 6e/6u-e(u), e'>O. This consideration may become important in the Chilean case as a high level of capacity utilization may start to generate inflationary pressures that will be underestimated if predicted with parameters corresponding to a macro regime with more slack. (Pressures to change the wage indexation coefficient could also be observed if inflation accelerate, though for the current levels of inflation in Chile these pressures may not be very serious yet).

Finally, it is worth to mention that the coefficient that measures the impact of changes in the rate of devaluation on inflation (0. 731) is much higher than the coefficient of the output gap (a feature appearing also in other empirical studies on inflation in Chile, Corbo, 1985 and Jadresic 19S5). Therefore, it is important to be aware that the exchange rate policy is bound to have a quantitatively significant effect on the rate of inflation in Chile.

# 4. Policy Exercises

With the model parameterized we are in conditions to carry out some policy exercises for Chile. As discussed at some length, the model flavour is that the qualitative effects of different policy instruments are regimedependent; therefore we have to make some assessment on the dominant growth regime under which the policy exercises take place. As Table 1 in the first section shows the Chilean economy in 1988 operated with little excess capacity, and less so in 1989, getting close to what we have termed as a capacity constrained-growth regime. Then the exercises are carried out, mainly under this regime. Furthermore, for the sake of completeness the demand constrained and inflationary regimes are also explored.
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**An increase in public spending (in social sectors) of 31 of potential GDP**

The first exercise we are dealing with is an increase in current public spending of 3Z of (potential) GDP directed to social sectors. According to Larrain's (1987) calculations this would be the approximate magnitude of the required initial internal transfer to low income grouDs in order to allow them (in a period of 5 years) to get above the poverty line and satisfy their basic needs requirements in terms of food, housing and basic services. Table 3 suauuarizes the effect of an increase in 3 percent of potential GDP of public spending in the capacity constrained growth regime.
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**Table 3**

> Effects of an **increase in public spending of 3S of** (potential) GDP. JCSapacity constrained-growth reglime

|base year<br>solution<br>(1)|solution with a**3Z**<br>increase in the government<br>spending share<br>(2)|difference<br>(2)-<br>(1)<br>percentage<br>(3)|
|---|---|---|
|rate of growth<br>of GDP,_Z_<br>6.43|5.36|-<br>1.07|
|real exchange<br>110.27<br>rate (index)|104.88|-<br>5.39|
|real wages<br>100.00<br>(index)|104.36|4.36|
|rate of growth<br>of GDPZunder a<br>5.90<br>dominant fiscal<br>constraint|5.26|-<br>0.64|
|______________|||
|a balanzed increase|||
|increase in public<br>6.43<br>spending (matched by<br>an increase in fiscal|6.43|0.0|
|revenues of 3 points of GDP)|||

A main result of Table 3 is that an (unbalanced) increase in the public spending share of 3? slows the rate of growth of GDP by 1Z . This effect is due to the reduction in public savings (taxes and/or other type of public spending remain unchanged in this simulation). The fall in public savings, in turn, leads to a reduction of domestic savings that forces (given foreign savings) to cut a-,regate (and public) investment and decelerate growth. As displayed in Figure 4 the increase in government spending shifts
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backward the SS locus (at a given real exchange rate, the rate of growth g has to be lower to accommodate a lower level of domestic saving). Given the FF schedule the system gets a new equilibrium with both lower growth and a lower real exchange rate. The real appreciation is 5.4Z (given a fixed nominal exchange rate, domestic prices have to fall to preserve goods market equilibrium at full capacity). On the other hand, real wages rise by 4.42 (see bottom part of Figure 4) and labor enjoys higher real wages but slower employm'ent growth. In terms of income distribution, labor and low income groups are expected to benefit from higher social spending.

In the case the fiscal gap is binding the slowdown in GDP growth is - 0.62, given a public sector horrawirng requirements target. However, it is worth mentioning the simulation in the bottom of Table 3, that shows that a fully balanced increase in public spending; that is, an increase in expenditure matched by an equivalent increase in fiscal revenues -- for example due to an increase in income taxes or the value added tax -- will not affect the rate of growth of GDP because fiscal savings remain unchanged in a balanced fiscal expansion at full capacity.

A main lesson of this exercise is that in order to avoid a trade-off between income distribution (pursued through an unbalanced fiscal expansion) and growth in a capacity-constrained economy, it is necessary to avoid a reduction in government savings. Since the terms of the trade -off are not trivial, this will require to finance the additional public spending in social sectors with increased taxation and/or reduced government spending in other sectors.
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> **Debt Reliefs a** reduction ln **intereat** payments on foreign debt

A second policy exercise we will explore here is a reduction in interest payments abroad of 3? of potential GDP; either as a consequence of cutting the effective interest rate paid on existing debt and/or because the country obtains a reduction in its outstanding principal as a part of a comprehensive debt relief scheme.

In terms of our model this policy shall affect the three constraints. The externai gap i's relaxed in proportiorn to the improvement in the c:urrent acccunt associated with the 32 reduction in r'*. To deter-mine the impact of _the_ intereet payments reduction on the other two gaps we make the assumption that 2/3 of the fall in r'* is shared by the public sector (that amounts to 2? of potential GDP) and 1/3 (say 1? of potential GDP) is shared by the private sector.

The fiscal constraint is relaxed in proportion to the increase in government savings associated with the reduction in public debt servicing abroad. Given a value of the psbr (public sector borrowing requirements), this leaves room for an increase in public investment. The saving constraint improves because public savings increase, the transfer abroad is reduced and the private sector saves more. The latter in response to the perceived increase in real disposable nat'onal income as a consequence of lower interest payments serviced by the private sector. In addition, this eff-ct could be greater if a cut in taxes is envisaged, following the reduced obligations of the public sector with foreign creditors.
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Table 4 Effects of a reduction in interest payments abroad of 3Z of (potential) GDP. - (capacity constrained growth **regime)**

||base year<br>solution<br>(1)|solution with a 32<br>reduction in interest<br>payments abroad.<br>(2 )|difference<br> <br>(2)-<br>(1)<br>percentage<br>(3)|
|---|---|---|---|
|rate of growth<br>ofGDP-|*.43|8.1|+1.67|
|real exchange<br>rate(index)|110,27|102.13|-<br>8.14|
|real wages<br>(index)<br>______________<br>rate of growth<br>of GDPZunder<br>a dominant fiscal<br>constraint|100.0<br>5.9|106.6<br>6.55|+6.6<br>+0.65|

As Table 4 shows, the gains in terms of acceleration in the rate of GDP growth following the 3Z of GD? reduction in interest payments abroad are significant: 167Z. On the other hand, the real exchange rate appreciates in 8.14Z and real wages rise by 6.6Z (the mark-up is held constant). In terms of figure 5 both the SS and the FF schedules shift upward. The fall in the equilibrium real exchange rate is due to the relatively larger shift in FF because of the improvement in the current account following the reduction in interest payments abroad. Clearly there is an improvement in the standard of living reflected in both higher real wages and accelerated growth.

The public finances also improve, and provided the resources released from reduced public debt servicing are channeled towards an increase in public
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inveitment, the rate of growth of GDP accelerates by 0.672 when the fiscal gap is binding.

# A reduction in the **mark-up rate of 4** percent.

The last exercise we explore is a reduction in the mark- up rate of 4Z. This distributive cum competitiveness-enhancing policy may be accomplished through a cut in tariffs or by rising profit taxes. Incidentally, a cut in niark-ups is qualitatively equivalent in its impact on prices to a _cut_ in indirect taxes i.e., a reduction in the value-added tax rat~e, 8.s was done in Chile in 1988. Of course, the distributive and fiscal effects may be different.

To trace out the macro effects of the reduction in the mark-up we need first to define how it is distributed between higher real wages and a higher real exchange rate. For simplicity we shall assume that both increase in the same proportion, say 4 percent. This satisfies our price equation (28) written in rate of growth form, modified to allow for a change in the mark-up, formally:

- **_6_** _(1+T )I_ (l+r) - at w - _x)_ + (l-)(@ + 1* - X where w -ir a + -r* -r 0.04 - - **6** (1+r)/l+r - - (-0.04)

The exercise will be carried-out in a demand constrained-inflationary growth regime as depicted in figure 6; whose numerical values (base year and policy solution) are shown in Table 5.
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# **Table** 5

Zffects of a reductlon **in the mark-up** rate of 4S (demand constrained-lnflationary growth **reiLm)**

||base year<br>solution<br>(1)|solution with a<br>42 reductionin<br>the mark-up rate<br>(2)|difference<br>(2)-<br>(1)<br>percentage<br>(3)|
|---|---|---|---|
|rate of growth<br>of potenttial<br>GDP 2|5.65|6.0|0.35|
|rate of capacity<br>utilization (inde%)|95.00|96.4|1.4|
|real exchange rate<br>(index)|100.0|104.0|4.0|
|real wages<br>(index)|100.0|104.0|4.0|
|__________________<br>rate of inflation||||
|on impact|17.1|13.1|-4.0|
|*permanent'|17.1|17.4|0.3|

As Table 5 shows a reduction in the mark-up by 42 increases moderately the rate of growth of potential GDP, 0.35Z, and increases the rate of capacity utilization by 1.4Z. Growth accelerates because of the positive effect of the lnduced real depreciation on foreign exchange availability and imports of capital goods, dominates over the negative effect of the lower current account deficit on aggregate savlngs. In terms of Figure 6, the outward shift in FF, the foreign gap locus, outweighs the downward shift in the SS schedule or savings gap. On the other hand, the expansionary effect of the cut in the markup - the rate of capacity utilization rise in 1.4Z -- is due to the positive
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effect of increased investment and net exports (external competitiveness rises) on aggregate demand and output.

What happens with inflation following the reduction in the mark-up ? The base year model solution for inflation is **i** - 0.223 (u-l) + 0.131 (o + r*) equal to 17.12 for u- 0.95, e- 0.20 and r - 0.05. Maintaining the same rate of devaluation and foreign inflation, the 'permanent" increase in inflation is 0.32 (r - 17.4Z) and is associated to the new (higher) rate of capacity u'tilization.

However, inflation is reduced won impact' (giveln the initial rates of capacity utilization, devaluation and foreign inflation) due to the cut in the mark-up rate; inflation being equa. to r - 17.1 - 4.0 - 13.1 percent.

# 5. Conclusions

The preceding analysis provides a framework to examine the macroeconomic constraints for sustained growth in a small open economy. A three gap model framed in a disequilibrium setting that distinguishes between demand constrained, capacity constrained and inflationary-growth regimes is the framework used for that purpose.

The model is calibrated with parameters for the Chilean economy and used to examine the effects of various macro policies with some distributive content. The main results can be summarized as follows: i) An unbalanced increase in government spending (in social sectors) of 32 of potential GDP, will slowdown the rate of growth in GDP by 12 in a capacity constrained-growth regime. The cut in government savings is the driving force oehind this result, given a certain current account deficit. In turn the real
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**exchange rate appreciates** (5.4Z) and real wages rise (4.42) after the increase in public spending. The adverse side effect on growth of this transference program could be avoided with an increase in taxation or a reduction in other public spending items.

ii) A reduction of interest payments abroad of 3Z of CDP, in a capacity constrained situation, would accelerate the rate of GDP growth by 1.7Z, reduce the real exchange rate by 8.1Z and increase real wages in 6.6 percent. An improvement ir ;he current account. along with a relaxation of the fiscal and saving gaps, gives rise to che acceleration in growth. The new equilibrium in the goods market _ar.d_ the balance _of_ payments requires now a lower rea' exchange rate therefore allowing a higher real wage.

iii) A cut in the mark-up rate of 42 increases external competitiveness and real wages simultaneously, allowing the rate of capacity utilization to increase by 1.42 and growth of potential GDP to accelerate by 0.352 (demand constrained regime). Finally inflation, won impact," would be reduced by 4Z.

iv) In regard to the macro constraints for the Chilean economy in the years ahead the balance of payments and the fiscal budget can ba considered as binding if a turnaround in copper prices take place as many observers predict. On the other hand, the level of productive capacity seems to be also a main macroeconomic constraint for expansionary demand policies at least in the short to medium run (in 1989 in the aggregate, no idle capacity seemed to exist). Therefore, an increase in savings and investment is of paramount importance to suppsrt growth on a sustained basis. Finally, inflation is currently at moderately low levels in Chile, however as the economy hovers around full capacity utilization and growth keeps high, some inflationary pressures may be mounting, a trend not to be disregarded in itny medium term assessment of the
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Chilean economy.
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<!-- Start of picture text --> Figure Xtffects . of in incrcsse in 1 ublic upending of 3t of<br>potential GDp (cap&cjty constrained-&rovth regime)<br><!-- End of picture text --> <!-- Start of picture text --> 5-<br>GDP grovth<br>rate<br>p<br>6.4<br>104.3 110.3 real exchange ratetr<br>100.0<br>104.36/<br>real vage<br>W/p<br><!-- End of picture text -->
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<!-- Start of picture text --> figure 5. Effect. of a reduction in interest paymnts<br>abroad of 31 of Potential GDP (capacity constrained<br>growth regime)<br>GDP growth<br>rate<br>8.1<br>6.4 G<br>St<br>102.1 110.3 real exchange<br>rate, or<br>100.0<br>106.6<br>real wages<br>V/p<br><!-- End of picture text -->
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<!-- Start of picture text --> Figure 6 Effecta of a reduction in the mark-u; rate<br>of _ Z . (demand constrained and inflationary<br>growth regiaes)<br>g c<br>GDP grovth rate<br>F~~~~~<br>0.95 0.964 rate of capacity<br>utilization,u<br>A I<br>13.1<br>17.1<br>17.4 \<br>rate of<br>inflation<br><!-- End of picture text -->