Portfolio balance approach to international capital movements: A case of Chile, 1975-1985

This dissertation argues that net capital flows in Chile during 1975-85 were influenced by the differential between the interest rate on net foreign assets and the foreign interest rate, by institutional factors such as capital controls, and by risk factors. In addition, the presence of capital controls contributed to the effectiveness of monetary policy in stabilizing the economy. This dissertation employs a macroeconomic portfolio balance model of international capital movements. The model integrates the goods and financial assets markets together with the net capital flows equation in order to capture the effect of the real and monetary variables on the net capital flows. These effects are presented in a comparative static analysis of asset portfolio adjustments in response to changes in the capital controls, changes in risk factors associated with net capital flows, the real interest rate, and real income in a general equilibrium framework. The model is tested against the monthly data of Chile during 1975-85. The estimated results of the structural equation confirm that net capital flows were affected by the portfolio adjustments, resulting from interest rate differential, by a capital control variable, and risk factors. The dissertation, therefore, suggests that monetary policy was effective in the short-run due to the presence of capital controls and that substitutions of the base money and domestic assets for net foreign assets generated net capital flows. The dissertation evaluates the outcomes of an alternative exchange rate policy and timing of liberalization of the capital account by simulating historical values of these policy outcomes. It concludes that the fixed exchange rate policy during June 1979-June 1982 constituted a policy mistake, but that the timing of liberalization of the capital account in Chile was correct.