Fiscal Dominance and Inflation Targeting: Lessons from Brazil
47 Pages Posted: 17 Mar 2004
There are 2 versions of this paper
Fiscal Dominance and Inflation Targeting: Lessons from Brazil
Fiscal Dominance and Inflation Targeting: Lessons from Brazil
Date Written: March 15, 2004
Abstract
A 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 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.
Keywords: Inflation targeting, fiscal dominance, debt dynamics, Brazil, default exchange rate
JEL Classification: E5, F4, H6
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Inflation Targeting in Emerging Market Economies
By Arminio Fraga, Ilan Goldfajn, ...
-
Fiscal Dominance and Inflation Targeting: Lessons from Brazil
-
Fiscal Sustainability and Monetary Versus Fiscal Dominance: Evidence from Brazil, 1991-2000
By Evan Tanner and Alberto Ramos
-
Signaling Fiscal Regime Sustainability
By Francesco Drudi and Alessandro Prati