Fiscal Dominance and Inflation Targeting: Lessons from Brazil
AbstractA standard proposition in open-economy macroeconomics is that a central-bank-engineered increase in the real interest rate makes domestic government debt more attractive and leads to a real appreciation. If, however, the increase in the real interest rate also increases the probability of default on the debt, the effect may be instead to make domestic government debt less attractive, and to lead to a real depreciation. That outcome is more likely the higher the initial level of debt, the higher the proportion of foreign-currency-denominated debt, and the higher the price of risk. Under that outcome, inflation targeting can clearly have perverse effects: An increase in the real interest in response to higher inflation leads to a real depreciation. The real depreciation leads in turn to a further increase in inflation. In this case, fiscal policy, not monetary policy, is the right instrument to decrease inflation. This paper argues that this is the situation the Brazilian economy found itself in in 2002 and 2003. It presents a model of the interaction between the interest rate, the exchange rate, and the probability of default, in a high-debt high-risk-aversion economy such as Brazil during that period. It then estimates the model, using Brazilian data. It concludes that, in 2002, the level and the composition of public debt in Brazil, and the general level of risk aversion in world financial markets, were indeed such as to imply perverse effects of the interest rate on the exchange rate and on inflation.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10389.
Date of creation: Mar 2004
Date of revision:
Publication status: published as Giavezzi, Francesco, Ilan Goldfajn and Santiago Herrera (eds.) Inflation Targeting, Debt, and the Brazilian Experience, 1999 to 2003. Cambridge: MIT Press, 2005.
Note: EFG IFM ME
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Find related papers by JEL classification:
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
- F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-06-07 (All new papers)
- NEP-IFN-2004-06-07 (International Finance)
- NEP-MON-2004-06-07 (Monetary Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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"A Dual Liquidity Model for Emerging Markets,"
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American Economic Association, vol. 92(2), pages 33-37, May.
- Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
- Arminio Fraga & Ilan Goldfajn & André Minella, 2003.
"Inflation Targeting in Emerging Market Economies,"
Working Papers Series
76, Central Bank of Brazil, Research Department.
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