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Inflation Targeting and Debt: Lessons from Brazil

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  • Carlo A. Favero
  • Francesco Giavazzi

Abstract

Studying the recent experience of Brazil the paper explains how default risk is at the centre of the mechanism through which an emerging market central bank that targets inflation might lose control of inflation--in other words of the mechanism through which the economy might move from a regime of 'monetary dominance' to one of 'fiscal dominance'. The literature, from Sargent and Wallace (1981) to the modern fiscal theory of the price level has discussed how an unsustainable fiscal policy may hinder the effectiveness of monetary policy, to the point that an increase in interest rates can have a perverse effect on inflation. We show that the presence of default risk reinforces the possibility that a vicious circle might arise, making the fiscal constraint on monetary policy more stringent.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10390.

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Date of creation: Mar 2004
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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.
Handle: RePEc:nbr:nberwo:10390

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  1. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1993. "Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," IMF Staff Papers, Palgrave Macmillan, vol. 40(1), pages 108-151, March.
  2. Alexius, Annika, 2002. "Can Endogenous Monetary Policy Explain the Deviations from UIP," Working Paper Series, Uppsala University, Department of Economics 2002:17, Uppsala University, Department of Economics.
  3. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall.
  4. Dirk Niepelt, 2004. "The Fiscal Myth of the Price Level," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 119(1), pages 276-299, February.
  5. Uribe, Martín, 2002. "A fiscal theory of sovereign risk," Working Paper Series 0187, European Central Bank.
  6. Carlo Ambrogio Favero & Francesco Giavazzi, . "Why are Brazil´s Interest Rates so High?," Working Papers 224, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  7. Olivier Blanchard, 2004. "Fiscal Dominance and Inflation Targeting: Lessons from Brazil," NBER Working Papers 10389, National Bureau of Economic Research, Inc.
  8. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1992. "Capital Inflows and Real Exchange Rate Appreciation in Latin America," MPRA Paper 13843, University Library of Munich, Germany.
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