What is the Effect of Domestic Demand Shocks on Inflation in a Small Open Economy? Chile 2000-2021

This study decomposes the factors that determined inflation in Chile during the period 2000-2021. We find that the main determinants of domestic inflation are variables of external origin and the exchange rate. Domestic demand has played a rather limited role as an inflationary factor. In general, in normal periods, increases in domestic demand explain no more than 20% of observed inflation. The average monthly inflation observed during the 2000-2021 period reached 0.3%, which means that domestic demand increases in normal periods explain a monthly inflation of 0.06%. Surprisingly, the extraordinary periods of rapid acceleration in demand as a result of highly expansionary fiscal policies and/or of the large withdrawals from pension retirement savings had a rather modest effect on the acceleration of inflation. Only in the last 5 months of 2021 we can detect some effects of the expansion in domestic demand on inflation. This study corroborates an expected fact in a small and open economy like Chile's: most domestic price changes are determined by foreign price changes.