Currency crisis and fiscal adjustment

Alexandre Schwartsman ()

Brazilian Journal of Political Economy, 1999, vol. 19, issue 1, 3-29

Abstract: We believe that the balance-of-payment crisis literature can offer the basis tounderstand the current economic turmoil in Brazil. According to our calculations the realexchange 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 policydesigned to reduce the appreciation) imposes a heavy burden on monetary policy: coveredinterest 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 interestrates, accepted by the government, the weight of stability in the government loss functionseems to be much higher than the assigned to unemployment (or growth). Yet – despite suchpreferences – the existence of a large budget deficit imposes objective limits on the use ofinterest 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 crucialelement to sustain the current FX policy. JEL Classification: F31; F41; F32.

Keywords: Currency crisis; capital flows; exchange rate regime; balance of payments (search for similar items in EconPapers)
Date: 1999
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