Fiscal cyclicality and exchange rate pass-through in Chile

Abstract

This paper explores how fiscal policy cyclicality influences exchange rate pass-through (ERPT) to inflation in Chile—an inflation-targeting (IT), copper-exporting economy that uses a cyclically-adjusted budget balance rule. It answers three questions: (i) How does fiscal cyclicality influence ERPT? (ii) How do copper price shocks interact with fiscal cyclicality and ERPT? (iii) How does the currency of invoicing change these dynamics? Using a exploratory empirical approach with a proposed windowweighted mean estimator and a DSGE model that allows for local currency pricing (LCP) or dominant currency pricing (DCP), I find that fiscal cyclicality does not have a significant effect on unconditional ERPT. However, conditional on a copper price shock, countercyclical fiscal rules lead to significantly higher ERPT—up to 10 percentage points more for headline inflation. This effect amounts to roughly one-third of the ERPT reduction achieved under the adoption of the IT framework, with non-tradable inflation showing the greatest sensitivity. Although DCP amplifies overall pass-through, fiscal stance continues to influence short-run dynamics. These findings highlight the significant role fiscal rules play in domestic inflation transmission and the broader macroeconomic environment for monetary policy. It also highlights the need to establish mechanisms that enhance information-sharing between fiscal and monetary authorities, especially during periods of heightened copper price volatility