Cyclical Fluctuations in Brazil's Real Exchange Rate
The Role of Domestic and External Factors
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Author’s E-Mail Address: pagenor@imf.org; ahoffmaister@imf.org

This paper examines the effects of capital inflows and domestic factors on Brazil’s real exchange rate. It describes the analytical framework, and then estimates a near-VAR model linking capital flows, interest rate differentials, government spending, money-base velocity, and the temporary component of the real exchange rate (TCRER). Generalized variance decompositions indicate that world interest rate shocks largely explain medium-term fluctuations in capital flows and the TCRER. Generalized impulse response functions show that a reduction in the world interest rate (and, to a lesser extent, an increase in government spending) have significant effects on the TCRER and capital flows.

Abstract

This paper examines the effects of capital inflows and domestic factors on Brazil’s real exchange rate. It describes the analytical framework, and then estimates a near-VAR model linking capital flows, interest rate differentials, government spending, money-base velocity, and the temporary component of the real exchange rate (TCRER). Generalized variance decompositions indicate that world interest rate shocks largely explain medium-term fluctuations in capital flows and the TCRER. Generalized impulse response functions show that a reduction in the world interest rate (and, to a lesser extent, an increase in government spending) have significant effects on the TCRER and capital flows.

I. INTRODUCTION

The potentially adverse effect of large capital inflows on domestic inflation and the real exchange rate (as well as, ultimately, the current account) has been one of the main concern of policymakers in developing countries and transition economies in recent years. As argued in a number of recent studies, the composition of capital flows, the degree of price stickiness and the degree of nominal exchange rate flexibility have been important factors in determining the effect of capital inflows on domestic macroeconomic outcomes. In countries where capital inflows have taken the form of portfolio investment (as opposed to foreign direct investment), they have often been associated with an increase in consumption rather than investment. In turn, the increase in consumption has often taken the form of a large increase in expenditure on nontradable goods, thereby leading to a real appreciation. In countries where a fixed (or predetermined) exchange rate has been used as a nominal anchor to reduce inflation (as was the case in Argentina, for instance), inertial factors have led to upward pressure on prices of nontraded goods and have led to a real appreciation.2

Brazil’s experience in the early 1990s provides an interesting case to study the effects of capital inflows and macroeconomic policy response on the real exchange rate.3 Large net outflows were recorded in the 1980s, reflecting both the uncertainty associated with the “stop and go” approach to stabilization as well as the restrictions on access to world capital markets that the country faced in the aftermath of the debt crisis. In the early 1990s (as shown in Figure 1) Brazil recorded a surge in inflows, reflecting partly the fact that interest rate differentials became highly favorable to domestic currency denominated assets, and partly changes in the institutional environment.4 Immediately after the introduction of the Real Plan in mid 1994, capital inflows increased sharply. They fell substantially in early 1995, in the aftermath of the Mexican peso crisis. Capital inflows—in the form of both portfolio investment and foreign direct investment—resumed in the second half of 1995, as confidence in the exchange rate band system increased. Gross international reserves rose to record levels as of end-1995. In part because this increase posed problems for monetary management, the authorities took measures to limit capital inflows on several occasions during the past four years, as summarized in Table 1—with a limited degree of effectiveness (Garcia and Barcinski, 1996).

Figure 1
Figure 1

Brazil: Private Capital Inflows, Interest Rate Differential and the Real Exchange Rate

Citation: IMF Working Papers 1997, 128; 10.5089/9781451935486.001.A001

Notes: The interest rate differential is measured as the difference between the overnight interest rate in Brazil minus the 90-day U.S. T-bill rate and the ex post, one-month ahead rate of depreciation of the domestic currency-U.S. dollar exchange rate. In the lower panel, a rise is a depreciation.
Table 1

Brazil: Main Changes in Capital Controls, 1993-95

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The behavior of the real exchange rate during the recent inflows episode is illustrated in Figure 1. In addition to potential effects of capital flows, changes in exchange rate policy have also been important. For most of the second half of the 1980s, Brazil had a relatively flexible exchange rate policy; but under the heterodox stabilization programs of the late 1980s, however, the domestic currency was temporarily fixed in terms of the U.S. dollar or adjusted by less than past inflation. These policies brought about a marked appreciation of the exchange rate, as illustrated in Figure 1. After a devaluation of the domestic currency in late 1991, exchange rate management aimed at maintaining the exchange rate stable in real terms. In the context of the Real Plan, the authorities introduced on July 1, 1994 a new currency, the real, with a floating exchange rate subject to a floor of R$1 per U.S. dollar. The real appreciated rapidly vis-à-vis the U.S. dollar, both in nominal and real terms. Following the Mexican peso crisis, the authorities introduced exchange rate bands in early March 1995, and have maintained that policy ever since.5

This paper provides a quantitative analysis of the effects of capital flows (as well as domestic factors) on the short-run fluctuations in Brazil’s real exchange rate in the early 1990s. The importance of assessing these effects is well illustrated in the recent literature on capital inflows (see Agénor and Hoffmaister, 1996). The magnitude of the inflows recorded by Brazil (as well as several other developing countries) in recent years, and the fears that they could be subject to abrupt reversal, have raised concerns among policymakers regarding their capacity to contain monetary and credit expansion, control inflation, and most importantly avoid a real exchange rate appreciation and a deterioration in the external current account.

Section II provides the analytical background for our analysis of the effects of domestic (namely, an increase in government spending) and external (namely, a reduction in the world interest rate) shocks on capital flows and the real exchange rate. Section III estimates a near-VAR model linking capital inflows, interest rate differentials, government spending, money-base velocity, and the transitory component of the real exchange rate. Generalized variance decompositions are used to assess the relative importance of various factors in explaining fluctuations in the temporary (or cyclical) component of the real exchange rate. The effects of temporary shocks to government spending and the “world” interest rate (proxied by U.S. interest rates) are also assessed using generalized impulse response functions. The concluding section summarizes the main results of the paper and discusses the policy implications of the analysis.

II. ANALYTICAL BACKGROUND

A useful background framework for our empirical analysis of the effects of domestic and external shocks on capital flows and the real exchange rate in Brazil is the intertemporal optimizing model developed by Agénor (1997), which is summarized in Appendix I. The model considers an open economy in which four types of agents operate: households, producers, the government, and the central bank. The nominal exchange rate E (defined as the home-currency price of foreign currency) is devalued at the constant rate ε.6

Households supply labor inelastically, consume both traded and nontraded goods, and hold two categories of financial assets in their portfolios: domestic money (which bears no interest) and domestic government bonds. They also borrow on world capital markets. Real financial wealth, a, is thus given by

a=m+bl*,(1)

where m denotes real money balances, b real holdings of government bonds, and l* net borrowing from abroad. m, b and l* are all measured in terms of the price of the consumption basket.

Consumption decisions follow a two-step process: households first determine the optimal level of total consumption, and then allocate that amount between consumption of the two goods. The total cost of borrowing faced by households on world capital markets i* + θ consists of the sum of a risk-free interest rate i* and an endogenous premium θ, which is positively related to the outstanding level of foreign-currency debt of the household and some exogenous factors—reflecting, for instance, market sentiment.7 Optimality conditions yield (see Appendix I):

  • a money demand function, md, which is positively related to consumption and negatively to the domestic nominal interest rate;

  • demand function for foreign loans, L* (measured in foreign-curreny terms), which is inversely related to the difference between the domestic interest rate, i, and the sum of the risk-free rate on world capital markets and the devaluation rate, i* + ε; and

  • a dynamic equation for consumption c, which shows that total consumption rises or falls depending on whether the domestic real interest rate exceeds or falls below the rate of time preference.

The second stage of the consumption decision process yields the demand for traded and nontraded goods, cT and cN:

CN=δz1δc,cT=(1δ)zδc,(2)

where 0 < δ < 1 is the share of expenditure on nontraded goods, and z the real exchange rate—the relative price of traded goods in terms of home goods. The consumer price index P is

P=PNδE1δ,(3)

where PN (E) denotes the price of the home (traded) good, from which the inflation rate is derived.8

The economy produces both traded and nontraded goods, using capital and homogeneous labor. The capital stock in each sector is fixed, and labor is perfectly mobile across sectors. Technology for the production of both traded and nontraded goods is characterized by decreasing returns to labor. Labor demand is derived from the first-order conditions for profit maximization, and the equilibrium condition of the labor market determines the product wage in the traded good sector—which is negatively related to the real exchange rate. Supply of traded (nontraded) goods yTs(yNs) is positively (negatively) related to the real exchange rate:

yTs=yTs(z+),yNs=yNs(z).(4)

The central bank defends the prevailing exchange rate by converting at no cost domestic money into foreign money, and vice versa. There is no credit to other agents in the economy, so that the real stock of high-powered money ms is equal to the central bank’s stock of net foreign assets measured in foreign currency terms, R*:

ms=zδR*.(5)

Real profits of the central bank (interest and capital gains on its holdings of foreign assets) are transferred to the government, which consumes only home goods in quantity gN. The government balances its budget by levying lump-sum taxes τ (in real terms) on households:

τ=zδ1gN(i*+ε)zδR*.(6)

Finally, the model specifies equilibrium conditions for the home goods market

yNs=δz1δc+gN,(7)

and the money market:

ms=md,(8)

with the latter condition solved for the market-clearing interest rate.

The behavior of the economy over time can be described by a first-order differential equation system involving two variables: private consumption (which can jump on impact) and net external debt D = L*R*, measured in foreign currency terms, which evolves gradually over time, and is given by:

D˙=i*D+θL*+(1δ)zδcyTs,(9)

where the expression on the left-hand side is the sum of the trade balance (cTyTs) and the services account (i*D + θL*).

As shown in Appendix I, in the steady state the overall inflation rate and the rate of inflation in the price of home goods are equal to the devaluation rate, the real interest rate is equal to the rate of time preference, and the current account is in equilibrium. Net private indebtedness is positive as long as the pure rate of time preference of domestic private agents is greater than the foreign risk-free interest rate.9

In this setting, a permanent increase in government spending on home goods (financed by an increase in lump-sum taxes) has no long-term effect on the domestic nominal interest rate, which remains equal to the rate of time preference plus world inflation (see equation (A15) in Appendix I). It also has no long-run effect on foreign borrowing by the private sector, which depends (as indicated by equation (A16)) only on the difference between the world real interest rate and the rate of time preference. At the initial level of the real exchange rate, private consumption must fall to maintain equilibrium of the market for nontraded goods. Real money balances must therefore fall, as shown by (A17), since domestic interest rates do not change. The reduction in private consumption is proportionally less than the increase in government expenditure, so that total domestic spending on home goods rises and the real exchange rate appreciates to maintain equilibrium in the home goods market. Although the real appreciation tends to reduce output of traded goods, the trade balance surplus (which matches the initial deficit of the services account) must rise to maintain external balance—since the economy’s stock of debt D increases, and the services account balance deteriorates. This increase in debt results from the fact that net foreign assets held by the central bank R* (and thus the money supply) must fall to accommodate the reduction in the demand for real money balances, and from the fact that holdings of foreign assets by the private sector, L*, do not change.

On impact, since the increase in government spending raises households’ lifetime tax liability and thus reduces their lifetime wealth, private consumption falls immediately—to an extent that depends on the degree of intertemporal substitution. But the real exchange rate may now either appreciate or depreciate—depending on whether total spending on nontraded goods rises or falls. If the degree of intertemporal substitution in consumption is low, private consumption will change relatively little on impact, and total spending will increase—thereby leading to an appreciation of the real exchange rate on impact.

With a temporary increase in government spending, the adjustment path depends on the duration of the shock. Suppose that the degree of intertemporal substitution is sufficiently small, and that the shock is of a sufficiently long duration. Private consumption will again drop on impact and continue to fall for a while, and start rising subsequently.10 The real exchange rate appreciates on impact, and depreciates gradually afterward. It then begins to appreciate (in line with the increase in consumption), until the moment government spending returns to its pre-shock level. At that point in time, a discrete depreciation occurs. Throughout the interval of time during which the level of government spending increases, the current account remains in deficit and the economy’s external debt rises continuously. After the shock is reversed, the current account moves into surplus, and the external debt falls over time.

Consider now a permanent reduction in the world risk-free interest rate, i*.11 The long-run effects are a reduction in consumption, a depreciation of the real exchange rate, and an increase in foreign debt (a reduction in net holdings of foreign assets).12 The initial effect of the reduction in the cost of borrowing on world capital markets, as can be inferred from equation (A16) in Appendix I, is an increase in private foreign indebtedness. A reduction in i* has two types of partial effects: on the one hand, at the initial level of the economy’s stock of foreign debt, it lowers interest payments; on the other, since the increase in private foreign borrowing raises the premium-related component θL˜*, it tends to increase interest payments to foreign creditors. Assuming that the former effect dominates the latter, the services account tends to improve. Second, since the economy’s stock of debt also increases, debt service at the initial risk-free rate tends also to increase. it can be shown that the second effect tends to dominate, so that the net effect is a deterioration of the services account. Thus, to maintain external balance in the long run, the initial trade surplus must increase. Consumption must therefore fall. This leads to a depreciation of the real exchange rate, which in turn stimulates output of traded goods and further improves the trade balance. Since the nominal interest rate remains constant, real money balances—and thus official reserves—fall also (see equation (A17) of Appendix I). With foreign borrowing by private agents increasing, and net foreign assets held by the central bank falling, the economy’s external debt unambiguously rises.

On impact, a permanent reduction in the world interest raises private spending and leads to an appreciation of the real exchange rate. The reason is that wealth and intertemporal effects associated with this shock operate in the same direction: the reduction in i* not only encourages agents to save less and consume more today (the intertemporal effect), but it also lowers the debt burden and generates a positive wealth effect. Although the trade balance and the services account move in opposite direction (the former deteriorates, whereas the latter improves), the net effect is a current account deficit on impact—and thus an increase in external debt.

For a temporary reduction in the world interest rate, again, the expected duration of the shock matters for the adjustment path. Consider first the case where the period of time during which i* falls is sufficiently large. Consumption will jump upward on impact and fall continuously—until the shock is removed. The real exchange depreciates gradually, following an initial step appreciation. The current account moves into deficit during the first phase of the transition process; however, the depreciation of the currency and the reduction in consumption lead progressively to a restoration of external balance; afterward, the economy generates a current account surplus, and the stock of debt declines continuously over time, until the initial equilibrium point E is reached.

Suppose now that the length of time during which the world risk-free interest rate falls is relatively short. As before, there is an initial upward jump in consumption and a real appreciation. Consumption then starts falling. Throughout the period during which i* falls, the economy registers a current account surplus, that is, a reduction in external debt. After the shock is removed, the stock of debt begins rising over time. Intuitively, if the duration of the shock is sufficiently long, agents have an incentive to substitute intertemporally and increase consumption; the negative effect on the trade balance in that case outweighs the positive effect on the services account, so that the current account moves into deficit and external debt increases. By contrast, if the reduction in the world interest rate is expected to be short-lived, agents will not adjust their consumption path by much; the improvement in the services account will therefore outweigh the deterioration in the trade balance, and the current account will move into surplus—with external debt falling.

III. EMPIRICAL EVIDENCE

This section presents empirical evidence for Brazil of the size and importance of the links discussed above. The analysis is based on a near-vector autoregression (near-VAR) model that captures the key relationships emphasized in the analytical model.13 We begin by discussing the near-VAR model and the generalized VAR analysis used in this study. We then examine the variance decompositions and the impulse responses to two key shocks: a) a decline in the world interest rate, and b) an increase of government spending.

A. Near-VAR Model

The specific variables included in the near-VAR model are private capital inflows as a proportion of aggregate output (denoted ky), changes in the uncovered interest rate differential (Δidiff), government spending as a proportion of aggregate output (gy), money-based velocity (veloc), the change in the “world” interest rate (Δi*), and the temporary component of the real exchange rate (TCRER). To decompose the real exchange rate into a nonstationary (trend) component and a stationary one, the technique used here is the Beveridge-Nelson (BN) approach, as described in Appendix II.

The near-VAR model allows us to treat gy and Δi* as block exogenous variables in the system. This treatment is consistent with the idea that gy is a policy variable that the authorities control and with the fact that world interest rates (Δi*) are unlikely to be affected by domestic policies in Brazil. The endogenous block of the near-VAR consists therefore of ky, Δidiff, veloc and, TCRER. Precise definitions of all the variables, their time-series properties,14 and the statistical adequacy of the near-VAR model are discussed in Appendix II.

In line with the analytical model described in the previous section, where the stock demand of foreign assets is related to the level of the interest rate differential, we relate changes in the interest rate differential to capital flows in the empirical model. This specification of the empirical model is consistent with the fact that these series have a unit-root as discussed in Appendix II.

The focus on the TCRER in this study is mostly motivated by the assumption that, in line with the analytical framework described in the previous section, it is the stock of net foreign assets, rather than change in this stock (capital flows), that affect the trend (or equilibrium) value of the real exchange rate. The temporary component can be interpreted as transitory deviations for its equilibrium path resulting from short-term cyclical and speculative factors. We also note that our focus is due to the fact that it would seem overambitious to try to identify long-run equilibrium movements of the real exchange rate given the short time span covered by the available data.

The empirical specification captures the key features of the theoretical framework, namely, the view that capital movements respond not only to external factors (such as Δi*) but also to changes in domestic macroeconomic conditions (such as veloc and gy). The addition of money-based velocity plays the role of a control variable, meant to capture the indirect effects of changes in the money supply on capital flows through their impact on domestic interest rates.

The near-VAR model was estimated using monthly data over the period 1988:M6 through 1995:M9. The results presented in this paper are based on a model with five lags; the lag selection is discussed in Appendix III. In addition to seasonal dummies to control for seasonality, the near-VAR model included two dummy variables to control for the Real Plan (with a value of 1 from 1994:M7 onward) and for the “Tequila” effect that affected Brazil during the first quarter of 1995. These dummies have very small impact on the empirical results described below, but are nonetheless statistically significant.

B. Generalized VAR Analysis

The near-VAR model was used to variance decompositions and impulse response functions in a “generalized” VAR framework, as proposed by Koop, Pesaran, and Potter (1996). An attractive feature of this approach is that it does not suffer from the “compositional effect” inherent in standard VAR analysis. As is well known, variance decompositions and impulse response functions derived from standard VAR analysis, depend on the ordering of the variables used to obtain the orthogonal shocks.15 This dependence reflects the fact that changing the ordering changes the implicit linear combination of the VAR innovations used to obtain the orthogonal shock, that is, changing the ordering changes the “composition” of the orthogonal shock.

Generalized VAR analysis is based on re-thinking what is to be “recovered” from the estimated VAR (or near-VAR) model. Consider impulse responses. Typically a VAR is subjected to an orthogonal shock, and the impulse responses trace out the dynamic response of the model to that shock. Note that implicitly these impulse responses compare the evolution of the model following the shock to a baseline model not subject to the shock. Generalized impulse responses (GIR) build upon this idea and propose to look instead at a “typical” historical shock. GIR compares the “average” dynamic responses of the model given a “typical” historical shock and the history of the model, compared to the “average” baseline model not subject to the shock given the history of the model. Specifically, GIR compares the conditional expectation of a variable in the model given an arbitrary current shock vt and history ωt, to the conditional expectation of that variable given history:

GIR(xt+k,vt,ωt)=E[Xt+k | vt,ωt]E[Xt+k | ωt].

It is important to note that since the GIR captures the historically-observed information regarding shocks in the data, it does not pretend to recover the responses to a “pure” world interest rate shock. Likewise, the generalized variance decompositions (GVD) measure does not pretend to measure the percentage of the variance attributed to “pure” shocks, and hence would not typically add up to 100 percent.

C. Generalized Variance Decompositions

Table 2 presents the GVD for the main endogenous variables, namely Δidiff, ky and TCRER. At very short forecasting horizons movements of Δidiff are mostly associated with its own historical innovations, and with the historical innovations of veloc. As the forecasting horizon increases, however, the importance of historical innovations of gy increase and explain about 22 percent of the movements of Δidiff. It is interesting to note that historical innovations associated with Δi* appear to have a small role in explaining movements of Δidiff. These results suggest that monetary factors dominate the very short-run movements of idiff and that the importance of these factors diminishes in the “medium run” where fiscal policy appears to play a substantive role in explaining these movements.

Table 2.

Generalized Variance Decomposition

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Note: Based on the estimated near-VAR model discussed in the text. The percentage of the variance attributed to the historical shocks do not necessarily add up to 100.

The GVD for ky suggests that its movements at short forecasting horizons is driven almost exclusively by its own historical innovations. As the forecasting horizon increases, the importance of historical innovations associated with gy rise to about 10 percent. Interestingly, the evidence suggests a large role for external factors, that is, Δi*, in explaining movements in ky. These results suggest that movements in capital inflows are mostly due to their own historical shocks, although movements in world interest rates appear to play a role in the “medium” term. Our results confirm the importance of external (push) factors in determining movements in capital flows. This is line with some the available evidence, which suggests that the surge in capital flows to developing countries since the early 1990s was associated with “external” factors (see Calvo, Leiderman, and Reinhart, 1996).

The GVD for the TCRER suggests that its movements at short forecasting horizons are mostly associated with its own historical innovations. As the forecasting horizon increases to six months the historical innovations associated with Δi* explain about 20 percent of the movements of the TCRER. Interestingly enough, the evidence suggests that historical innovations associated with external factors (Δi*) appear to explain a large part of the movements of the TCRER in the medium term. Nonetheless, more than half of the movements of the TCRER are associated with its own innovations in the medium-term.16

D. Generalized Impulse Responses

Figure 2 contains the GIR for the change in the interest rate differential, the capital inflows-GDP ratio, and the TCRER. One-standard error bands for each variable are also shown.17 We consider in turn a shock to the “world” interest rate, and a shock to the government spending-output ratio.

Figure 2
Figure 2

Generalized Impulse Responses

Citation: IMF Working Papers 1997, 128; 10.5089/9781451935486.001.A001

Interest rate shock

A temporary (one-period only) reduction in Δi*—that is, a permanent decline in i*—leads on impact (and with a one-month lag) to a significant increase in the interest rate differential, a capital inflow, and an appreciation of the TCRER.18 Although there appears to be some cyclical movement in the interest rate differential in subsequent months, movements in capital inflows and the TCRER display considerable persistence: the inflow of capital continues to rise, and the TCRER continues to appreciate, four months after the shock. Thereafter both variables return slowly to their baseline values; moreover, these movements remain significant throughout the adjustment period.

How do these results compare with the predictions of the analytical framework described above? The response of capital movements and the (temporary component of the) real exchange rate is consistent with the qualitative implications of the model. The reduction in the rate of return on foreign assets leads, on impact, to a reallocation of private agents’ portfolios towards domestic assets. With agents being initially net debtors, the reduction in the world interest rate exerts a positive wealth effect; at the same time, it reduces the incentive to save. As a result of both factors, consumption rises, thereby exerting upward pressure on the relative price of nontraded goods.19

Government spending shock

A temporary increase in gy leads on impact to a significant reduction in the interest rate differential, with no immediate apparent movement in capital flows or the TCRER. However, the subsequent increase in the interest rate differential (between the second and sixth months after the shock) is accompanied by a small but significant inflow of capital and a short-lived appreciation of the TCRER. Capital flows show again some degree of persistence, but the TCRER does not.

The empirical evidence on the effects of an increase in government spending (which can be viewed as falling mostly on nontraded goods) can also be rationalized in terms of the model described earlier. The lack of response of the TCRER to the increase in gy on impact, and the subsequent small and short-lived response, may reflect an offsetting effect in private consumption. As previously emphasized, the response of private expenditure on impact depends on agents’ propensity to smooth their consumption path over time. What these results may imply, therefore, is that there could be some (albeit small) degree of intertemporal substitution.20 This implication of the results does not appear to be inconsistent with the available evidence for other Latin American countries (see Agénor and Montiel, 1996, Chapter 10).

The significant drop in the interest rate differential on impact is also consistent with the predictions of the model: at the initial level of the real money stock, a fall in private consumption requires a fall in the domestic interest rate to maintain equilibrium of the domestic money market. Private capital inflows appear to respond with a two-month delay.

IV. SUMMARY AND CONCLUSIONS

The purpose of this paper has been to examine the links between capital inflows and the real exchange rate in Brazil. The first part presented the analytical background, consisting of a two-sector intertemporal optimizing model of an economy in which agents face imperfect world capital markets. A key feature of the model is the interaction between domestic interest rates (determined through the equilibrium condition of the money market), private foreign borrowing, consumption decisions, and the real exchange rate. The second part estimated a near-vector autoregression model linking capital inflows, the interest rate differential, government spending, money-base velocity, and the temporary component of the real exchange rate, calculated with the Beveridge-Nelson technique.

The model was estimated using monthly data for the period 1988-95. Variance decompositions suggest that in the short run, fluctuations in the interest rate differential are associated with domestic monetary factors; at longer horizons, government spending plays a larger role. Fluctuations in capital inflows are driven almost exclusively by their own historical innovations, at short forecasting horizons. In the longer run, shocks to the world interest rate play a substantial role. Fluctuations in the TCRER are also associated mostly with its own historical innovations at short forecasting horizons, and with world interest rate shocks at longer horizons.

The analysis of impulse response functions indicates that a permanent reduction in the world interest rate leads almost immediately to an increase in the interest rate differential, a capital inflow, and an appreciation of the TCRER. Although there appears to be some cyclical movement in the interest rate differential in subsequent months, movements in capital inflows and the TCRER display considerable persistence. A temporary increase in government spending leads to a significant reduction in the interest rate differential on impact, and with some lag, to a small but significant inflow of capital (which again shows some degree of persistence over time) and a short-lived appreciation of the TCRER.

We caution, however, that care is needed when interpreting these results as the high frequency data used, in particular capital inflows and government spending, are not without caveats. High frequency data for short-term credit lines are not available and thus our measure of net private capital inflows is not as comprehensive as we would have liked. In principle we could have incorporated these flows by interpolating the annual short-term credit. We are, however, apprehensive about using mechanical methods because little high frequency information could be gained by “smoothing” this highly volatile series and using a related series (the world interest rate, for instance) for interpolation introduces information favoring a particular hypothesis (in this case, changes in world interest rates). Regarding government spending data, those available to us refer to expenditure on a cash basis and cover outlays by the federal government only. The problems of mismatching the moment when the expenditures are accrued and the moment when the expenditures are recorded become more evident with higher frequency data.21

While it is impossible to know with certainty how these data limitations affect our results, we speculate that had high frequency data on short-time credit lines been available the impact of world interest rates would have been even more pronounced. This is because a decline in world interest rates, by reducing the cost of short-term borrowing, would tend to reinforce net capital flows to Brazil. It is also possible that the important role of world interest rates in explaining capital inflows in the medium and long term would be reinforced and perhaps extended to the short run as well. We are less clear, however, how our results might be affected by using a more comprehensive measure of government outlays.

Cyclical Fluctuations in Brazil's Real Exchange Rate: The Role of Domestic and External Factors
Author: Mr. Willy A Hoffmaister, Mr. Carlos I. Medeiros, and Pierre-Richard Agénor