Before the COVID-19 pandemic, researchers intensely debated the extent of the decline in the so-called equilibrium or natural rate of interest. Given the recent sharp increase in interest rates, we revisit this question in an emerging bond market context and offer a Chilean perspective using a dynamic term structure finance model estimated directly on the prices of individual Chilean inflation-indexed bonds with adjustments for bond-specific liquidity risk and real term premia. Beyond documenting the existence of large and time-varying liquidity risk premia in the bond prices, we estimate that the equilibrium real rate in Chile fell about 2 and a half percentage points in the 2003-2022 period and has remained low since then with model projections only suggesting a gradual reversal in coming years. Instead, recent increases in real interest rates in Chile are driven by spikes in the liquidity and term premia of inflation-indexed bond prices.
We evaluate the behavior of the UIP relationship around monetary policy and global uncertainty shocks using event studies. We find that the covariance between exchange rate movements and changes in long-term yield differentials is conditional on the nature of shocks. A model of partial arbitrage between domestic and US bond markets predicts that tighter US monetary policy appreciates the dollar while increasing US yields relative to domestic bonds, a response that is consistent with UIP forces, while global uncertainty shocks appreciate the dollar while raising domestic yields relative to US bonds, exacerbating the widely documented UIP violation. The empirical analysis supports these mechanisms, specially for developed economies. For emerging economies, both relationships are weaker, consistent with more pervasive currency stabilization policies that mute the FX response at the expense of higher volatility in longer yields. Our results suggest a more nuanced interpretation of the unconditional failure of the UIP.
This paper studies the gains from wage flexibility in a New Keynesian model with price and wage rigidities and incomplete asset markets. When a fraction of households consume solely out of their labor income and have no access to financial markets, the real wage, and therefore, the relative nominal rigidities between wages and prices, directly determine the economy’s aggregate demand. We show that when wages are flexible relative to prices, economic downturns are accompanied by a pronounced decline in real wages, which depresses aggregate demand, and exacerbates the economy’s volatility. In this context, we conclude that enhancing wage flexibility when prices are highly rigid is an undesirable policy prescription.
We analyze spillovers of financial conditions on international portfolio bond flows. We document significant US financial conditions spillovers using data from developed and emerging countries. To disentangle the nature of spillovers, we rely on panel spatial autoregressive models, and third market competition on global trade flows to capture direct and indirect effects. We find that 30% of US spillovers are due to indirect effects in mutual funds with a regional-target investment focus.
We show significant US monetary policy (MP) spillovers to international bond markets. Our methodology identifies US MP shocks as the change in short-term Treasury yields around Federal Open Market Committee meetings and traces their effects on international bond yields using panel regressions. We emphasize three main results. First, US MP spillovers to long-term yields have increased substantially after the 2007–2009 global financial crisis. Second, spillovers are large compared with the effects of other events, and at least as large as the effects of domestic MP after 2008. Third, spillovers work through different channels, concentrated in risk-neutral rates (expectations of future MP rates) for developed countries, but predominantly on term premia in emerging markets. In interpreting these findings, we provide evidence consistent with an exchange rate channel, according to which foreign central banks face a trade-off between narrowing MP rate differentials or experiencing currency movements against the US dollar. Developed countries adjust in a manner consistent with freely floating regimes, responding partially with risk-neutral rates and partially through currency adjustments. Instead, emerging countries display patterns consistent with foreign exchange interventions, which cushion the response of exchange rates but reinforce capital flows and their effects in bond yields through movements in term premia. Our results suggest that the endogenous effects of currency interventions on long-term yields should be added into the standard cost-benefit analysis of such policies.
This work analyzes the behavior of long-term interest rates for several developed and developing economies, identifying the risk-neutral and term premium components under different methodologies. The authors analyze which of these two channels affected interest rate movements in different monetary policy regimes. Also, they quantify the transmission of U.S. long-term yield to these economies using a spillover index. They find that movements in long-term interest rates in different monetary policy regimes are related to changes in the term premium for most countries. The findings also suggest a heterogeneous behavior in the United States to other economies. In developed economies, long-term interest rates are affected in both components (risk neutral and term premium) mainly through the U.S. risk-neutral channel, whereas in developing countries, the evidence suggests that the relevant transmission channel is the term premium, which is affected by the U.S. term premium.
The downwards trend exhibited in Chile’s nominal term structure since 2003 has been a common pattern shared by other developed and developing economies. To understand the behaviour of the nominal yield curve in Chile, we rely on an affine dynamic term structure model which allows the term structure to decompose into the expected short-term interest rate (related to the monetary policy expectation) and the term premium. We show that most of the fall of long-term interest rates as well as its dynamics are related to the term premium rather than the expected short-term interest rate. Moreover, we find evidence that term premium is driven primarily by the US term premium and domestic nominal uncertainty derived from expected inflation.
We examine the impact of income heterogeneity on macroeconomic dynamics by analyzing households' expenditure decisions across different goods over the business cycle. Using Chilean transaction-level expenditure data, we observe income-dependent systematic variations in expenditure shares over the business cycle, suggesting a relevant role for non-homothetic preferences. We embed these preferences into a Heterogeneous Agent New Keynesian model and analyze their influence on the transmission of fiscal transfers. We find two novel channels associated with non-homotheticities: aggregate consumption sensitivity to income and insurance through expenditure switching. In a calibration for Chile, we find that non-homotheticities lead to substantial amplification of the effects of fiscal transfers of up to fifty percent.
This paper studies how household heterogeneity shapes the response to commodity price shocks. Using data from Chile and other emerging economies, we document that (i) low/high-income households spend relatively more on food/services, and (ii) more than 40 percent of the population is financially constrained. We build a multi-sector New Keynesian model for a small open economy with household heterogeneity and non-homothetic preferences. Non-homothetic preferences dampen the effect of a commodity price shock by inducing a reallocation in the consumption basket towards more income-elastic goods: an economy with non-homothetic preferences generates aggregate responses 29 percent lower.
This paper studies the role of input-output (IO) linkages in the transmission of commodity price fluctuations. Empirically, the positive correlation between commodity prices and GDP decreases in the degree of IO linkages. In a model of a commodity-exporting economy where international markets set the commodity price, IO linkages reduce the demand for inputs by the commodity sector, dampening the level of income of the country after a positive commodity price shock. In a calibrated version of the model, the elasticity of GDP to commodity prices would be at least 7% higher if the commodity sector had been 10% less connected.
As a senior economist at the Central Bank of Chile, I have contributed with the following material (in Spanish)