Monetary Policy and Central Bank Roles
Interest Rates and Monetary Policy
In analyzing interest rates on money demand, we should first discuss the role of interest rates with the flow of international capital, especially in short-term movements called “capital flight.” These are exclusively financial interests where resources go to foreign countries that offer attractive interest rates and affect the national economy through exchange rate variations.
In Chile today, interest rates are higher than in most developed countries. This attracts foreign capital, which appreciates the domestic currency. Profits are earned not only from interest rates but also from the difference in the exchange rate if this situation is massive. The central bank’s only defense to protect the national currency is to require a high level of reserve requirements, which can be hampered by free trade agreements. Fortunately, both in Europe and the USA, a credit crunch has prevented a greater flow of foreign capital, which would have aggravated the peso appreciation.
Interest rates also affect countries with a fixed exchange rate policy with a lower nominal dollar, resulting in a real appreciated currency. This phenomenon, unless there is very tight control, leads to changes when foreign currency becomes scarce. As this policy does not encourage exports, the only way to bring in foreign currency is to pay high interest rates, which also affects the local market and ends with a generalized seizure.
The chart explaining the fixation of the exchange rate is the same as observed in a free market in macroeconomics.
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Central Bank
According to the 1980 constitution, the Central Bank is an autonomous body. However, the organic law granting this autonomy was enacted only in 1989.
The Central Bank is responsible for monetary, credit, and exchange policy. It must satisfy three objectives:
1. Maintain price stability.
2. Provide liquidity for the normal development of monetary transactions within the country.
3. Adequately provide the means for external operations and payments.
The policy is the responsibility of the Central Bank’s board, consisting of five directors, each with a 10-year term. The head of this council is its Chairman.
The Central Bank’s directors are nominated by the President of the Republic to the Senate for approval. The President elects the Chairman from among the directors when the previous Chairman’s term ends (with 2/3 Senate approval).
The Central Bank’s directors are dedicated and cannot have any other function or work, except for university teaching and participation in nonprofit organizations.
To meet its goals, the Central Bank fulfills several functions summarized in five activities:
1. Provide the legal currency of the country’s economy: This means that only the Central Bank issues and withdraws money. Money is usually printed at the mint or abroad on instructions from the Central Bank. Damaged notes are burned in Central Bank vaults.
2. Bank of banks: The Central Bank is the bank of banks. If a bank faces a transient liquidity problem, it may receive a loan for up to 90 days with board approval, which can be renewed if the problem persists. If the bank fails or the problem is permanent, the Central Bank may intervene and appoint a liquidator, leading the bank into bankruptcy.
In some cases, the Central Bank can finance specific programs through the banking system, either by directly injecting resources or rediscounting bills or notes.
3. International reserves manager: Each country should have foreign “hard” currency (like the US dollar) and gold reserves to meet its international commitments. The Central Bank manages these reserves.
If a country lacks these resources, usually after an external payments crisis, it obtains a loan from the International Monetary Fund under conditions expressed in a “Letter of Intent” to adopt sound economic policy, which has a high social cost.
Chile currently has a high level of international reserves. As the balance of payments surplus increases, these reserves will grow. The Central Bank invests these reserves primarily in fixed-income instruments such as US Treasury bonds.