A simple macro model for a small open economy facing a binding external constraint (Chile)

Abstract

In this paper a Keynesian macroeconomic model for a small open economy is used, which describes the functioning of the real part of the economy in the short run when facing a dominant external restriction. The main conclusions of this paper are: (1) In the Chilean case, a devaluation has a contractionary impact in the short run, i.e., a 10% real devaluation produces a 3.4% drop on the level of output. The non-fulfilment of the Marshall-Lerner condition accounts for only 30% of the output contraction, while the remaining 70% corresponds to the decline in consumption that is induced by the reduction in real wages. (2) When the economy has an external deficit, the adequate combination of exchange and fiscal policies to restore the Balance of Payments equilibrium which minimizes the decline of output depends on the magnitude of the devaluation. Thus, an ‘over-shooting’ in the exchange rate, together with a contractionary fiscal policy, would produce an unnecessarily deflationary impact in the short run. (3) The Chilean empirical evidence shows that when there is a dominant external constraint, the magnitude of the short run trade-off between real wages and employment is not very acute. The short-run elasticity of employment with respect to the real wage is 0.34.