A Bayesian Analysis of the Fiscal Dominance Hypothesis in Brazil

In this article, the evidence of fiscal dominance (FD) in Brazil, according to Olivier Blanchard, was tested using generalized impulse response functions (GIRFs) derived from a Bayesian Time-Varying Coefficient VAR model (BTVCVAR) for the period from January 2014 to September 2024. The GIRFs generated for periods in which the debt-to-GDP ratio was greater than or equal to 60% rejected the fiscal dominance hypothesis. It was also found that the GIRFs exhibited the same dynamics across different periods of the Brazilian economy. In other words, for the pre-pandemic and post-pandemic periods, their configurations overlap. The GIRFs reject the FD hypothesis because a positive shock to the Selic rate produced the following responses- a reduction in the inflation rate, an appreciation of the exchange rate, and a decline in sovereign risk, which characterizes a situation of monetary dominance (MD). At first glance, this result can be explained based on the following assumptions- the accumulation of foreign exchange reserves and the inflation-targeting regime (reflecting the credibility of the Central Bank) acted as a buffer that prevented the cost of public debt from contaminating the exchange rate channel and, consequently, inflation; and the channel of institutional confidence and the interest rate differential prevailed over the risk of insolvency.In this article, the evidence of fiscal dominance (FD) in Brazil, according to Olivier Blanchard, was tested using generalized impulse response functions (GIRFs) derived from a Bayesian Time-Varying Coefficient VAR model (BTVCVAR) for the period from January 2014 to September 2024. The GIRFs generated for periods in which the debt-to-GDP ratio was greater than or equal to 60% rejected the fiscal dominance hypothesis. It was also found that the GIRFs exhibited the same dynamics across different periods of the Brazilian economy. In other words, for the pre-pandemic and post-pandemic periods, their configurations overlap. The GIRFs reject the FD hypothesis because a positive shock to the Selic rate produced the following responses- a reduction in the inflation rate, an appreciation of the exchange rate, and a decline in sovereign risk, which characterizes a situation of monetary dominance (MD). At first glance, this result can be explained based on the following assumptions- the accumulation of foreign exchange reserves and the inflation-targeting regime (reflecting the credibility of the Central Bank) acted as a buffer that prevented the cost of public debt from contaminating the exchange rate channel and, consequently, inflation; and the channel of institutional confidence and the interest rate differential prevailed over the risk of insolvency.