Functions of the Central Bank of Chile

a) The Stability of Chile’s Currency

The Central Bank of Chile’s current basic constitutional law establishes in its third article that one of the basic objectives of this institution is to look out for the stability of Chile’s currency. This implies avoiding a deterioration in the value of the currency as a result of the price inflation. Thus, it is the Central Bank of Chile’s responsibility to ensure that inflation remains low and stable.

The importance of this objective of ensuring the stability of the country’s currency lies in the costs implicit in inflation. On one hand, higher inflation tends to distort the price system within the economy and as a result the information that prices provide does not permit the efficient allocation of resources. On the other, from a distributive perspective, inflation tends to hurt those who hold more of their wealth as money, that is, the poorest sectors. Thus, higher inflation negatively affects the level of economic activity and the population’s welfare.

For these purposes, the Central Bank’s powers are involved in regulating the amount of money and credit in circulation and the approval of rules in the monetary sphere. This is because of the direct relationship that has been empirically established between money and prices in the long term. Thus, the application of a strict and orderly control over the quantity of money constitutes the sole form of ensuring low, stable inflation over time.

The experience of developing countries, Chile among them, suggests that one of the fundamental causes of inflation arises when the Central Bank finances public expenditure. Thus, the 1980 Constitution of Chile expressly prohibits this. Similarly, the basic constitutional law of the Central Bank establishes that under no circumstances can the bank provide a guarantee or acquire documents issued by the State, its bodies or companies.

b) Normal Functioning of Domestic Payments

Article 3 of the Central Bank’s basic constitutional law establishes the second fundamental objective of the Bank, which is to ensure the normal functioning of domestic payments.

The domestic payment system refers to the set of institutions and instruments that facilitate the realization of transactions within the economy. In general, this includes as its main components currency and demand deposits (checks) in banks. These are the instruments most used in transactions carried out by economic agents; a flaw in their normal functioning would affect the whole payment system, producing real damage to the economy.

Checking account deposits represent that part of the payments system that is directly linked to the financial system. In effect, one of the basic functions of the banking system is to provide the economy with a means of payment, for which it holds deposits in checking accounts, which can be withdrawn at any time at par value. If for some reason, the documents representing these deposits (checks) were to lose their value as a means of payment (for example, due to an atmosphere of general mistrust), then an important part of the payments system would be affected.

The purpose of ensuring the normal functioning of domestic payments is closely tied to the anti-inflationary objective, because if the currency loses its value very quickly (high inflation) domestic money will cease to be used, thus damaging the payment system. However, the need to watch over the payment system does not arise only from the negative externalities that its eventual failure could produce in the economy, but also in its intrinsic fragility. In effect, banks invest resources from demand deposits in less liquid assets, so that if all these deposits were to be withdrawn simultaneously, banks would face a liquidity problem. If this were to become general, thus producing mistrust throughout the financial system, the negative effects on general economic activity could turn this initial, liquidity problem into one affecting the solvency of the entire banking system.

To avoid this, the basic constitutional law provides the Central Bank with the possibility of serving as a “lender of last resort”, that is, a provider of liquidity to those institutions that face a temporary cash flow problem. Moreover, it has regulatory powers over the financial system, mainly (but not exclusively) over those aspects related to the payment system, such as reserve rates for deposits, the power to authorize banking firms to pay interest on checking accounts, the power to authorize banking companies to provide credits related to checking accounts, and to approve overdrafts on same, among others.

Finally, the general banking law rules that, in the case of an institution being forced to declare itself in liquidation, demand deposits and obligations will be paid with the resources to be found in cash, deposited in the Central Bank or in the technical reserve. Thus, demand deposits are totally guaranteed and their payment is made immediately upon a bank being declared in liquidation. Thus, the role of the Central Bank is to keep the payment system functioning, providing the funds necessary to meet demand obligations of institutions that run into problems.

c) Normal Functioning of External Payments

Article 3 of the basic constitutional law also establishes that the Central Bank of Chile must ensure the normal functioning of external payments.

External payments refer to the set of transactions that residents in one country carry out in another where they are not resident, and which are also registered in the balance of payments. Thus, ensuring their normal functioning means avoiding a crisis in the balance of payments, that could interrupt these transactions.

The normal functioning of external payments is of vital importance for an economy open to international trade such as Chile's. A significant part of national output is exported, while a significant proportion of the inputs and capital goods needed for domestic production is imported from the rest of the world. If, due to a financing problem, these transactions between residents and non-residents are interrupted, serious damage would be inflicted on the national economy.

With this objective, the law empowers the Central Bank to determine Chile’s foreign exchange policy. Today, this means that the market determines the reference exchange rate, in the context of a free-floating exchange. The Central Bank is empowered to intervene in this market under exceptional circumstances, and must publicly inform of and justify these interventions.

Similarly, the basic constitutional law establishes that the optimum scenario is one free of foreign exchange restrictions. Nonetheless, the Central Bank is empowered to establish temporary restrictions. There has been full freedom for exchange operations and international capital movements since September 1999, when the last restrictions on foreign exchange were lifted.