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program—one that had been developed by a group of economists who came to be dubbed the "Chicago boys" because almost all of them had done graduate work at the University of Chicago. In 1975, he appointed some of these economists to his cabinet. They cut government spending and employment sharply, repriva-tized enterprises that had been taken over by the Allende government, and removed controls on prices, wages, imports, and exports. These changes permitted a drastic reduction in money creation. Inflation promptly slowed. As measured by the deflator implicit in calculating real gross domestic product (GDP), inflation fell from 694 percent in 1974 to half that (342 percent) in 1975 and to less than 46 percent in 1979. After a difficult transitional year, during which real income fell by 13 percent, the economy boomed. Real growth averaged 7.5 percent a year from 1975 to 1980. Foreign exchange rates fluctuated until June 1979, with the Chilean peso permitted to depreciate in response to the higher rate of inflation in Chile than in the United States and other industrialized countries.

In June 1979, the Ministry of Finance took the fateful decision to which I referred in the first paragraph: it decided to peg the Chilean peso to the U.S. dollar, that is, to specify a fixed rate at which the Chilean central bank would stand ready to exchange pesos for U.S. dollars and U.S. dollars for pesos. The government took this step in the hope of cementing the gains that had already been made in reducing inflation and of facilitating further reduction.

The basis for such a hope is a familiar one: committing Chile to a fixed exchange rate would provide external discipline that would inhibit the excessive creation of money. As long as Chile kept its commitment, it gave up any independent control over the quantity of money, which would, have to be whatever was necessary to keep prices in Chile compatible with prices in the United States (to state the requirement in somewhat oversimplified terms). For two years the hope was fulfilled. In 1980 inflation fell to 29 percent, in 1981 to 12 percent, while output grew by 8 percent in 1980, 6 percent in 1981 (see Figure 1). Maintenance of the fixed exchange rate was facilitated by, and no doubt also contributed to, a very large inflow of capital from abroad, especially in 1981 (Harberger 1984, table 1).

Unfortunately for Chile, not long after it pegged the exchange rate, the United States adopted a severely restrictive monetary policy in order to stem the inflation of the 1970s. The U.S. inflation peaked in 1980 and then decelerated sharply, accompanied by a severe recession that lasted until late 1982. The U.S. change in policy was accompanied by a major appreciation in the foreign exchange value of the U.S. dollar—by 18 percent from 1980 to 1981, another 13 percent from 1981 to 1982, and a further 23 percent from 1982 to 1985. If Chile had continued to let the exchange rate fluctuate, it could have offset the appreciation in the U.S. dollar by letting the Chilean peso depreciate vis-a-vis the U.S. dollar while remaining fairly stable vis-a-vis other major currencies. As it was, that option was ruled out. Chile was forced to let its currency match the appreciation of the U.S. dollar against other foreign currencies. To add to Chile's problems, the dollar price of oil more than doubled from 1979 to 1981, and the dollar price of copper, Chile's major export, fell, by more than 25 percent from 1980 to 1981 and by nearly 40 percent from 1980 to 1982.

Figure 1

Chile: Year-to-Year Percentage Change in Real Income and Deflator, 1977–1986

SOURCE: Banco Central de Chile, 1986.

The combined effect of the appreciation of the U.S. dollar, the doubling of the price of oil, and the near halving of the price of copper was disastrous for the Chilean economy. At prior peso prices and wages, Chilean goods became much more expensive to countries other than the United States in terms of their own currencies, and these countries' goods, other than oil, became cheaper in pesos. In addition, the recession in the