Inflation: The Root of the Problem • 1980- Runaway inflation was ranging from 100% to 3,000% a year.
Introduction of Real • 1994-Real is introduced. Was intended to go up against the dollar. It was set up in the way that it could depreciate at controlled rate against the dollar. • High interest rates were created and were intended to fight the high inflation by reducing an incentive to hold money.
Introduction of Real Cont. • 1980-1994- Real experiences an appreciation which makes it undesirable in the foreign market. Therefore: the interests rates go up causing bank failures and unemployment. Inflation is still 2,669%
Rise of National Debt • 1995- Consistent current account deficits begin • CA deficit reached 4.2% of GDP in 1998
1997- Foreign direct investment grew by 140% over the year before due to high interest rates • Inflation is down to 10% There is still high fiscal deficit. • Perhaps, interest rates were high due to the government repayment of its debt. (Brazil was trying to finance its current account).
Are We There Yet? • 1998-Unemployment rose to 14% from 6%. Interest rates went up while foreign reserves declined. Brazil’s high spending discouraged foreign investors. • IMF injected $40 billion in economy. (not certain what triggered foreign investors’ change in response. Could be the reaction from the Russian financial crisis or the realization of the current account deficiency).
Devaluation of Real • 1999- Brazil devaluates Real by 8% Real’s value continues to loose value down to 40%. Recession occurs due to the government’s attempt to correct the fall of the currency.
Expectations of the fall of Real There is a current account deficit due to the increase in government spending. So the investors expect devaluation in the domestic currency. Therefore there is an upward shift of foreign returns curve.
Ineffectiveness of Sterilization • In order for sterilization to be effective there should be a change in exchange rate. When fiscal policy expanding, the central bank has to buy foreign assets and increase the money supply to keep the exchange rate constant. Perhaps, increasing money supply leads directly to inflation. So, the other choice the government has is to sell domestic assets to decrease the money supply, but in turn it has to buy foreign assets to keep the foreign exchange rate constant. • Inflation cycle is created as the result making this policy an effective.
Citations • www.haver.com • http://www-personal.umich.edu/~kathrynd/Brazil.w06.pdf