Cyclical Fluctuations in Brazil's Real Exchange Rate: The Role of Domestic and External Factors


WP/97/128-EAWP/97/128


Cyclical Fluctuations in Brazil's Real Exchange Rate: The Role of Domestic and
External Factors

by Pierre-Richard Agénor, Alexander W.Hoffmaister and Carlos I. Medeiros

summary


The paper examines the links between capital inflows and the real exchange
rate in Brazil. The first part presents the analytical background. The second
part estimates a 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 is estimated using monthly data for the period 1988.95. Variance
decompositions suggest that, in the short run, fluctuations in capital inflows
are driven almost exclusively by their own historical innovations; in the
longer run, shocks to the world interest rate play a more substantial role.
Fluctuations in the temporary component of the real exchange rate are also
associated mostly with their 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
temporary component of the real exchange rate. Although there appears to be
some cyclical movement in the interest rate differential in subsequent months,
movements in capital inflows and the cyclical component of the real exchange
rate 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 temporary component of the real exchange rate. These
results are broadly consistent with the predictions of the analytical
framework.