Brazil’s booming economy has to tame “two wild horses” at the same time. A rising inflation rate coupled with a currency appreciating at a fast rate, is destabilizing the economy. With inflation rising at a rate of 6.3%, soon it will rise above the Central banks maximum target of 6.5%. Alongside, the Real has appreciated to 1.58 reais to a US dollar which is one of the highest rates since the Real has been allowed to float from 1991. The problem is such that the “economic cost of bringing down inflation is too high”, as this will harm the economic growth of Brazil. Hence drastic actions are not seemingly attractive.
Using a monetary policy where the central bank is increasing interest rates, is making Brazil attractive to foreign investment. In turn valuing the currency and raising prices of exports in the economy. Among many ideas floating to resolve this issue, the central bank plans to implement “macro prudential measures” to curb inflation without raising the Real. President Dilma Rousseff vows to control inflation at any cost. In order to control this problem, the President will have to deal with minimum wages with industries already suffering due to high level of import consumption.
In an attempt to understand and analyze Brazil’s economy and its current problem, I will use the macroeconomic concepts of Inflation and Exchange Rates. My aim will be to explain the problems in detail and then propose ideas using these concepts to achieve a healthier Brazilian economy, aiming for a lower rate of inflation and a depreciation of the Real. Along with looking at problems like, the local industrialists’ dilemma of increasing dependency on imported goods and services and the affect on consumers.
Theory Review and Analysis
Brazil’s government and industry need to control the rising rate of inflation and the ever valuing real. This is because inflation in the economy is causing general price levels to increase making everything more expensive. This is making production of goods and service more costly which translates into the fact that export production is now more costly and automatically less competitive on the international trade market. In order for Brazil to bring down inflation to a familiar rate of 4.5% from 6.3% and would result in “too high” of an economic cost. This could mean that in order to bring down inflation the economy would have to implement a contractionary fiscal policy (a fall in government spending and increase in taxes). A fall in government spending would be harmful to the economy at this point because already prices are rising in the economy, making people worse off in real terms, demanding aid from the government and an increase in taxes could worsen the already worse off individuals.
These events can result in workers being discouraged to work due to high tax rates, subsequently increasing the rate of unemployment-adding another problem to the economy. More so, government spending in Brazil is integral at the moment as much expenditure is needed to better infrastructure and society as Brazil is hosting the Rio Olympics till 2016. In efforts to curb inflation, the Central bank implemented a contractionary monetary policy raising interest rates to decrease the spending in the economy and promote saving. Brazil’s 11.25% interest rate is comparatively higher than other countries, attracting foreign investment from all over the world be it long term investment or short term investment. This is also referred to as “hot money”. Hot money is the regular flow of money between financial markets as investors attempt to ensure they get the highest short-term interest rates possible. Hot money flows from low interest rate yielding countries into higher interest rates countries by investors looking to make the highest return.
This flow of investment results in the appreciation of the Real as shown in (Fig 1)(appreciation of real against dollar) We can see that the high interest rates spur an attraction towards the Real by foreigners, who now demand more of that currency(from D1 to D2).Simultaneously, the Brazilian locals notice that at the moment their own country offers a high interest rate making it more profitable to invest in the home land. Consequently demanding less of the competing currency (Dollar), in turn supplying less of the Real( supply of real shifts from S1 to S2). A combination of changes in the demand and supply of Real on the Floating market results in the Real appreciating (P TO P2). This is why there are inflows of $35 Million into the Brazilian economy. In order to keep inflation in check and not affect the currency value, the bank is choosing to implement macro prudential measures.
Here we can see that the central bank is increasing the bank reserve-requirements which is an increase in the reserve rate ratio. Restricting the commercial banks to give out loans, this will decrease the volume of money in the economy. Again a contractionary monetary policy measure to curb inflation. More so, in order to curb inflation the finance ministry is raising taxes on consumer credit, foreign bond issues (decreasing the sale of securities to foreign investors), overseas loans and derivatives margins (brokers input on loans made out to buy securities).By implementing “macro prudential measures” not only can inflation be curbed but also the currency can be devalued as this would spur about less demand as borrowing would be more of a hassle. Which is what Guido Mantega, finance minister of Brazil also believes as he thinks the Real can be brought down 1.4 to the dollar. Many think the Brazilian economy should allow the Real to appreciate on the floating exchange market and welcome the inflow of foreign investment.
Along with this, they should continue trying to curb inflation but cutting public spending and continue limiting loans made out from banks to gradually decrease inflows letting the currency depreciate. However the government is correct in not being completely for this idea as they are uncertain if the industries can cope with the highly valued real for the time being as it is already difficult to compete on the world trade market as exports are not as competitive as now exports are seemingly more expensive since the local currency is appreciating over competing currencies like the US dollar. This is evident as the FIESP, an industrialist’s trade body in Sao Paulo voices that members are already struggling, and that the share of imported industrial good in total consumption was at an all-time high. This is because locals are now importing more goods as imports are seemingly cheaper as the Real is appreciating.
PERSONAL OPINION AND CONCLUSION
I think the “macro-prudential measures” suggested by the central bank would be much helpful as this would contract the spending in the economy by raising taxes on consumer credit, higher bank reserves. More so, other measures like curtailing foreign bond issues and raising derivative margins will play a big role in decreasing the spending power within the economy. Even though a contractionary monetary policy is already in effect (rising interest rates and lower levels of money supply).A tighter fiscal policy in terms of taxing income needs to be implemented. This will result in decreased disposable income allowing the inflationary gap in the economy to decrease, which is the difference between planned aggregate expenditure and the planned output at full capacity, resulting in greater economic stability. (fig 2). More so, I feel that in order to tame the exchange rate, first the inflation rate must be dealt with. This is because the purchasing power parity(PPP),the law of one price, explains that if two countries are consuming the same basket of goods, the exchange rate between the two currencies is determined simply by the relative price levels in the two countries.
The rising dependency on imports by the Brazilian consumers is because of the high levels of inflation within their own country. This causes consumers to prefer imports and foreigners to not be attracted towards exports, which is the cry of the industrialists. This problem forces Brazilians to demand foreign (US CURRENCY) and for foreigner to decrease the supply of dollar in exchange for Real as they do not want the Brazilian industrial goods.(fig 3,explains the PPP).Showing that since Brazil has a higher rate of inflation than its competitor United States of America in this example, it has an devaluing exchange rate. The Brazilian government should also look into protectionist measures such as tariffs or quotas. These would be adequate as they are not too extreme hence retaliation would not be an issue and this would curb the current expenditure on imported goods and services, “as the share of imported industrial goods in the total consumption was at an all-time high.” Implementing a tariff (fig 4) shows that the equilibrium price is R$6 in Brazil.
Whereas the same imported good costs $2.This reduces the local market share to 200units out of the 600 demanded at this price. Once the tariff of R$2 is implemented raising the price to R$4,the local market share increases significantly. As a long term measure, once there is greater stability in the Brazilian economy in terms of inflation. The government can think about devaluing their currency for a while to potentially boost the local industries in the global trade market along with working towards a favorable Balance of trade. This can result in the initial worsening of the balance of trade as the same industrial goods will be sold at a lower price and imports bought at a higher price but in time if the Marshal Lerner’s Condition is satisfied, in time the exports will be seen as more competitive on the global market and more will be in greater demand, and at the same time less will be spent on imports as now they will seem much more expensive due to the devaluation.
The Marshal Lerner’s Condition states that the balance of trade initially worsens but in time it turns into a positive trade balance if the (MLC) is satisfied. The MLC is satisfied when the sum of price elasticity of exports and imports (in absolute value) is greater than 1.And this can be illustrated by the J curve (fig 5).As it shows the initial worsening of the balance of trade and the later improvement in the balance of trade due to a devaluation in the exchange rate. This in turn also helps the local industries compete in the global markets and gives industrialists confidence in their own economy which is what Brazilian industrialists need.