Abstract

We believe that the balance-of-payment crisis literature can offer the basis to
understand the current economic turmoil in Brazil. According to our calculations the real
exchange rate requires a 15% to 20% devaluation so as to assure that the intertemporal balance-
of-payments constraint is not violated. Such appreciated currency (and the FX policy
designed to reduce the appreciation) imposes a heavy burden on monetary policy: covered
interest parity implies high real domestic interest rates in order to finance the current account.
Eventually the defense of the exchange rate requires an additional increase in interest
rates, accepted by the government, the weight of stability in the government loss function
seems to be much higher than the assigned to unemployment (or growth). Yet – despite such
preferences – the existence of a large budget deficit imposes objective limits on the use of
interest rates as a means to defend the currency. In the absence of a sharp fiscal adjustment monetary policy will no longer be credible. In this sense, the fiscal adjustment is a crucial
element to sustain the current FX policy.

JEL Classification: F31; F41; F32.