Policy. Reseatch, and External Affairs WORKING PAPERS Macroozonomic Adjustment and Growth Country Economics Department The World Bank April 1990 WPS 400 Macroeconomic Constraints for Medium-Term Growth and Distribution A Model for Chile Andr6s Solimano A foriial model that identifies the miajor macroeconomic conl- straints to maintain sustainable growth is specified and parame- terized for the Chilean economr. The nmrdel is also used to explore the macro effects of policies addressing poverty and incomiie distribution issues. I'hc R'K Re>arLh. and i x:cmna Affairs (Copesx dist t [IRS PRI: \ king Papce ro dthe'n,ae hthc of os if sx;9 grc and .enc uragc Lhe exchange If ideas among lHank staff and all ot'erc ntn stcrv In ies cNo 0, fz < 0 Imports of intermediate goods, normalized by y, are made a function of the real exchange rate and the level of capacity utilization (9) mz - he + hler + h2u h, < 0 , h2 > 0 Adopting a similar specification, for the imports of consumption goods, - 10 - (10) mc - Jo + Jler + J2u JC < °, J2 > 0 Total exports, in turn, will be a positive function of the real exchange rate, er, and the level of world demand, Y*. (11) X - VO + Vler + V2Y v1 > ° , v2 > 0 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: (12) F/y - B/y - s f = co + cl er + c2 u + c3 g + r + c4Y 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. (13) gf- 1/c3 ( s8f -co -cl er -C2 u - r * + c4Y* } 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 6er > 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 - (14) sf - wo + w1 er + w2 u + w3 g + w4Y* - 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, w4 <0 The condition savings equals investment, or saving gap, given by equation (3), normalized by the level of potential output, can be written as - (15) i - sp + sg +*f 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. (16) g5 -(k/1-kw3) { do + d, er +d2 u } 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 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 - (23) p- (1+T)(# w + t e p) 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. (24) w/p - l/p { 1/1+r - 0 ep*/p I - 16 - Suamrizing, the model can be reduced to five equations: the foreign exchange constraint equation (13), the savings constraint equation (16), the fiscal constraint represented by equation (22), equation (24) is the relationship between the real wage and the real exchange rate. The inflation sector of the model is presented below, equations (26) and (27) and is 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 capacity utilization, u , the real exshange rate, ep*/p , the real wage, w/p , and the inflation rate, i. Let us turn now to the three regimes defined in the model: the first one is a fix price -excess capacity regime where w, p, e are fixed ( i - 0 ) and the system is solved for g and u. This regime will be labeled as a demand constrained-growth regism, where growth takes place in an economy operating with excess capacity. One way to solve the system in this regime would be through the min. condition, for a given u. (25) g - min {gf, gs gg) Another way to solve the system in the demand constrained regime is to obtain simultaneously a solution for g and u assuming fix the real wage, ;he real exchange rate and the price level. This retains the fix price spirit of the disequilibrium models where, in a Keynesian fashion, quantities adjust (included now the rate of potential GDP growth). The second regime represents the case of an economy operating at full capacity u - 1, where wages and prices are flexible (e is fixed or 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 from full capacity use (u-i). Plugging equation (27) into (26) we arrive to the fo-1,ding expression for the rate of inflation: (28) r - i/i-00 { DE(u-l) + (l-D)(e + r*) ) In general this regime may be consistent both with a demand constrained or a capacity constrained situation in the goods market. Figure 1 to 3 show the graphical solution of the model for each growth-regime and the comparative static is developed in next section with an empirical application to Chile. Figure ls Demand constrained - growth reainm Ł F growth S rate G G capacity utilization, u The downward sloping FF s hedule represents the external constraint, equation (13), in the space (g,u) for given values of the real exchange rate and interest payments abroad. It is negatively sloped since an increase in u - 19 - raises current goods imports, reducing the resources available to import capital goods hence forcing to cut-down growth, 6g,/6u < 0. The SS schedule representing the saving gap, equation (16), is upward sloping since an increase in u rises domestic savings generating more resources to invest, 5gs/6u > 0 The GG schedule is the fiscal constraint, equation (22), is also positively sloped since an increase in the rate of capacity utilization increases net revenues of the government, thus producing more resources to finance a higher level of public investment that could support more rapid growth. On the other hand, the schedule is assumed to be flatter than the SS schedule. The equilibrium solution for g and u arises from the intersection of the three schedules SS, FF and GG. In case these lines do not intersect at the same point, some assumption is needed with respect to which gap is not binding in the system in order to avoid an overdetermined system. - 20 - Figure 2. Capacit, constrained-growth reCete growth rate G real exchazge rateep *Ip real vage,vlP 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 (24). The relatiouship 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 would allow a real depreciation of the exchange rate - a gain in external competitiveness - that need not to be accompanied by a squeeze in real wages. - 22 - Figuro 3. Inflationar,-arowth resime growth rate capacity utilization,u rate of inflation 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. - 23 - 3. A Numerical Calibration of the Model for Chile In this section the model specified in the previous section is calibrated. The calibration procedure uses coefficients fro.ia three sources: i)econometric estimates of some key functions (like import and export 3quations, investment equationb,price equations, ii) values calculated divectly from time series or iii) assumed plausible coefficient values. To assure consistency to the base year values coming from National Ac .ounts and Balance of Payments 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 initial values of the variables of the model and some parameters used to estimate the 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 an 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 savings and public sector net revenues -hat exceed averages propensities). The foreign 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 - 24 - 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 trade- off 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 - 25 - economy were foreign exchange constrained, in the sense that the upward shift in FF dominates, the opposite result for the rate of growth of potential GDP will be obtalned; namely a cut ln real waget would accelerate growth). Therefore, a demand constrained-growth regime is consistent both with an accelerationist or stagnationist response of growth to a cut in real wages. The final result will depend on the specific parameters values that make the saving gap or the foreign gap effect to dominate following a cut in real wages. Turning to the parameterization of the fiscal constraint we get 88- 0.010 + 0.049 u. Then, it is apparent that the trade-in coefficient 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 * - r - - 0.81 (a + r* -X). Then a real devaluation of 102 will reduce real wages by 8.1? holding the mark-up 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 and a coefficient of response of nominal wages to the output gap of 0.25. Combining the structural equation if inflation with the wage equation we get the following semi-reduced equation for the rate of inflation i - 0.223 (u -1) + 0.731 (a + Xr ). It is interesting to note that the sensitivity of inflation to the output gap is rather moderate (0.223). However, we can expect that the effect of an increase in capacity utilization on inflation depends also on how close the economy is to full capacity, mainly trough an increase in the response of nominal wages growth to a higher rate of capacity utilization in the goods market. In fact, - 26 - 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 regime- dependent; 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. - 27 - 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. - 28 - Table 3 Effects of an increase in public spending of 3S of (potential) GDP. JCSapacity constrained-growth reglime base year solution with a 3Z difference solution increase in the government (2) - (1) spending share percentage (1) (2) (3) rate of growth of GDP, Z 6.43 5.36 - 1.07 real exchange 110.27 104.88 - 5.39 rate (index) real wages 100.00 104.36 4.36 (index) rate of growth of GDP Z under a 5.90 5.26 - 0.64 dominant fiscal constraint ______________ a balanzed increase increase in public 6.43 6.43 0.0 spending (matched by an increase in fiscal 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 - 29 - 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. - 30 - 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. - 31 - Table 4 Effects of a reduction in interest payments abroad of 3Z of (potential) GDP. (capacity constrained - growth regime) base year solution with a 32 difference solution reduction in interest (2) - (1) payments abroad. percentage (1) ( 2 ) (3) rate of growth *.43 8.1 + 1.67 of GDP - real exchange 110,27 102.13 - 8.14 rate (index) real wages 100.0 106.6 + 6.6 (index) ______________ rate of growth of GDP Z under 5.9 6.55 + 0.65 a dominant fiscal constraint 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 - 32 - 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. - 33 - Table 5 Zffects of a reductlon in the mark-up rate of 4S (demand constrained-lnflationary growth reiLm) base year solution with a difference solution 42 reduction in (2) - (1) the mark-up rate percentage (1) (2) (3) rate of growth of potenttial GDP 2 5.65 6.0 0.35 rate of capacity 95.00 96.4 1.4 utilization (inde%) real exchange rate 100.0 104.0 4.0 (index) real wages 100.0 104.0 4.0 (index) __________________ 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 mark- up - the rate of capacity utilization rise in 1.4Z -- is due to the positive - 34 - 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 * 35 - 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 - 36 - Chilean economy. - 37 - Figure . Xtffects of in incrcsse in 1ublic upending of 3t of potential GDp (cap&cjty constrained-&rovth regime) 5- GDP grovth rate p 6.4 104.3 110.3 real exchange ratetr 100.0 104.36/ real vage W/p - 38 - figure 5. Effect. of a reduction in interest paymnts abroad of 31 of Potential GDP (capacity constrained growth regime) GDP growth rate 8.1 6.4 G St 102.1 110.3 real exchange rate, or 100.0 106.6 real wages V/p - 39 - Figure 6 Effecta of a reduction in the mark-u; rate of _ Z . (demand constrained and inflationary growth regiaes) g c GDP grovth rate F~~~~~ 0.95 0.964 rate of capacity utilization,u 13.1 A I 17.1 17.4 \ rate of inflation - 40 - APPENDIX In this appendix we shall present the initial values of some key variables as ratios of potential GDP of the base year, 1987. We include also the parameterized form of some relatiorships of the model that are not included in the main text (constant terms correspond to adjusted values for the calibration year). GDP growth rate: 0.055 rate of capacity utilizations 0.946 total consumption: 0.757 gross investment rate: 0.16 total exports: 0.31 total imports: 0.284 consumption goods imports: 0.096 intermediate goods imports: 0.13 capital goods imports: 0.059 resource surplus: 0.03 net factor payments abroad: 0.081 net current transfers: 0.0057 current account deficit: 0.045 national savings: 0.114 national private savings: 0.064 current government spending : 0.296 current government spending: 0.246 public savings: 0.05 public investment: 0.069 - 41 - fiscal deficit : 0.019 (public sector borrowing requirements) growth -investment relationship g- 0.0017 + 0.333 i imports of consumption goods Mc - 0.035 - 0.146 er + 0.218 u imports of intermediate goods mz - - 0.0958 - 0.0286 er + 0.269 a imports of capital goods mk - 0.079 - 0.02 er + 0.645 i total exports x - - 0.191 + 0.191 er + 0.319 Y* private investment rate in - 0.051 - 0.23 i8 + 0.059 u average direct tax rate = 0.2 marginal saving rate = 0.2 - 42 - Bibliography Arellano, J.P. 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(Editor) 1988, Desarrollo Econdmico en Democracia. Ediciones Universidad Cat6lica de Chile. Ch. 2. (1989), "Chile: The Challenges of Democratic Development" mimeo Harvard University. Marfan, M. and P. Artiagoitia (1989) " Estimaci6n del PGB Potencial: Chile 1960- 1988" Colecci6n de Estudios Cieplan 1 27, Diciembre. Meller, P. and A. Solimano (1987), "A Simple Macro Model for an Small Open Economy Facing a Binding External Constraint (Chile)" Journal of Development Economics, North-Holland, June. Pollack, M. y A. Uthoff (1986), "Pobreza > Mercado del Trabajo: Aspectos conceptuales y Metodologia" Prealc, Santiago, Chile. Rodriguez, J. (1985), La Distribucion del Ingreso y el Gasto Social en Chile Ilades; SAnti8gom -Chile. Solimano, A. 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