Estimating the liquidity effect in post-reform Chile: do inflationary expectations matter?

In this paper, we estimate the dynamic effects of domestic money supply shocks in Chile over its post-reform era. We analyze Chile since inflationary expectations could be very sensitive to changes in the money supply, given past inflationary experience. In the context of a VAR model containing both Chilean and US variables, we identify money supply shocks using long-run monetary neutrality and block exogeneity restrictions. Our findings suggest that in Chile over the period from 1977 to 1998, unexpected domestic money supply shocks have had a positive impact on interest rates, in the short-run, and a negative impact on real money balances. This differs markedly from the estimated responses of the US. The findings are consistent with the notion that, at least in Chile, inflationary expectations are very sensitive to news about the nominal money supply, possibly due to high inflationary uncertainty and the lack of credibility of monetary reforms. Our results are generally robust to alternative model specification and identifying restrictions.