the effects that fluctuations in the copper price have on the real exchange rate and, consequently,
on competitiveness.
The adjustment coefficients show that the Chilean interest rate is equilibrium error correcting
in the long and medium run. The domestic price is equilibrium error increasing in the long run but
equilibrium error correcting in the medium run. Thus, if the domestic price is above its longrun
benchmark value, in the medium run both the domestic inflation rate and changes in the domestic
interest rate will tend to increase, generating an increase in the equilibrium error term
ˆ
v
1,
t
. In the long
run, however, the domestic price will tend to increase, which generates a decrease in
ˆ
v
1,
t
. To restore
the longrun equilibrium, the domestic interest rate starts increasing.
The second polynomially cointegrating relationship,
˜
β
0
2
˜
x
t
+
˜
d
0
2
4
˜
x
t
, can be interpreted as a
longrun relationship between the interest rate spread, trendadjusted prices, and changes in the
nominal exchange rate and is expressed as:
22
When
α
ij
=
0, the corresponding
d
ij
is not shown in Equations (
27
) and (
28
). Furthermore, only
d
ij
coefficients with a

tvalue
 ≥
2.5 are shown.
Econometrics
2017
,
5
, 29
16 of 21
i
d
,
t

i
f
,
t
=
0.03 ˜
p
d
,
t

0.28 ˜
p
f
,
t
+
1.21
4
p
d
.
t
+
0.17
4
p
f
,
t
+
1.01
4
s
t

0.001
4
i
d
,
t
+
1.13
+
ˆ
v
2,
t
(28)
where
˜
p
f
,
t
and
˜
p
d
,
t
are, respectively, the trendadjusted prices in US and Chile and
ˆ
v
2,
t
∼
I
(
0
)
is the
equilibrium error. The equation shows that the interest rate spread is positively comoving with
the relative trendadjusted level of prices, domestic and foreign inflation rates, and changes in both
nominal exchange rate and domestic interest rate. This relationship might describe a central bank’s
reaction rule.
The Chilean trendadjusted price,
˜
p
d
,
t
, might tentatively be interpreted as a proxy for a longrun
indicator of the inflation target.
That is, given the US interest rate and US trendadjusted price,
if the domestic price is above (below) its longrun trend, the central bank may use contractionary
(expansionary) monetary policy that increases (decreases) the domestic interest rate.
The above
argument may be used to explain the relationship between the interest rate spread and the changes in
the nominal exchange rate. For example, the central bank may use contractionary monetary policy to
counteract inflationary pressures due to exchange rate depreciation.
The adjustment coefficients show that when the interest rate spread has been under its longrun
value, the domestic inflation rate and the domestic interest rate will tend to decrease in the medium
run. Furthermore, the domestic price is equilibrium error correcting to the central bank’s reaction rule
in the long run, whereas the domestic interest rate is equilibrium error increasing in the long run. Then,
if the interest rate spread is under its longrun equilibrium value, the domestic interest rate will tend
to decrease. This generates further decreases in the equilibrium error
ˆ
v
2,
t
. However, at the same time,
the domestic price will tend to decrease, so it starts to restore the equilibrium.
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 Summer '18
 Sagar Arora
 Exchange Rate, Inflation, The Land, Foreign exchange market, nominal exchange rate