Following an economic crisis and military coup in 1973, the country pursued a distinctive set of economic policies. These included liberalization of the domestic economy, structural reform of the social welfare system, and sharp reductions in trade barriers.
The strategies were focused on balancing the federal budget, reducing inflationary pressures, and stabilizing the currency. The initial actions attacked the fiscal deficit. The reformers raised income and consumption taxes, imposed a luxury tax, and cut all categories of government spending by at least 15%. The deficit fell from 25% of GDP in 1973 to 5% in 1974, and to zero in 1976. Monetary policy was tightened slightly, but inflation remained in triple digits and the current account deficit widened. When initial steps proved insufficient, monetary policy was tightened dramatically in 1975and wage controls were imposed.
These reforms led to a collapse in demand: GDP fell 13%, investment plummeted, and inflation-adjusted wages fell by 30%. The Allende government had imposed extensive controls on the exchange rate and international capital flows, but the Chicago Boys gradually dismantled these controls. High domestic real interest rates made it attractive for Chilean firms to borrow abroad and the resulting capital inflows led to an appreciation of the peso in 1976 and 1977. The government implemented a series of devaluations in 1978 and then fixed the exchange rate at 39 Pesos to the dollar in 1979. The fixed rate was designed to reduce inflation by changing inflationary expectations and, in the event inflation continued, by making imports more price competitive. The currency peg was maintained until 1982.
The reform o...
... middle of paper ...
...egan to recover. To many, Chile was the strong man of Latin America.18 But several problems lingered. GDP per capita still remained below its 1970 level, large capital inflows were being used to finance a consumption boom, and the combination of a pegged exchange rate and continuing inflation led to an overvalued peso. Local producers could not compete with cheap imports, causing the trade deficit to reach 15% of GDP in 1981.
These distortions were exacerbated by lax banking regulation. The large economic groups used their banking subsidiaries to borrow dollars cheaply in the Euromarkets and lend to other group members in pesos. Local banks, confident in the currency peg, raised cheap dollars abroad and lent locally in pesos at high rates of interest. Between 1978 and 1981, the capital account of the balance of payments showed an average net inflow of 12.3% of GDP.
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