Using the Exchange Rate to Fight Inflation Has Disadvantages

For Immediate Release: June 2, 2011
Contact: Dan Beeton, 202-239-1460

Washington, D.C. - A new paper from the Center for Economic and Policy Research takes a detailed look at the last decade of Brazil’s economic performance and concludes that while there has been a large improvement in both policy and performance since 2004, the most common macroeconomic analysis is flawed and is limiting the country’s growth and development.

“The common understanding that Brazil’s central bank raises interest rates in order to reduce aggregate demand, and thereby keep inflation under control, is wrong,” said Mark Weisbrot, economist and Co-Director of  the Center for Economic and Policy Research.  “As this paper shows, the central bank has met its inflation target over the last seven years through a continual real appreciation of Brazil’s currency.  This has consequences, and needs to be understood.”

The paper, "Macroeconomic Policy, Growth and Income Distribution in the Brazilian Economy in the 2000s," was written by Franklin Serrano, a Senior Research Associate at CEPR, and Ricardo Summa of the Institute for Economics at the Federal University of Rio de Janeiro. Serrano is also an Associate Professor at the Institute for Economics at the Federal University of Rio de Janeiro.

The Brazilian economy grew by 4.2 percent annually from 2004-2010, more than double its annual growth from 1999-2003 or indeed its growth rate over the prior quarter century.  This growth was accompanied by a significant reduction in poverty and extreme poverty, especially after 2005, as well as reduced inequality. The authors look at the combination of external changes and changes in policy that contributed to these results.

One important change was that the government switched to a more expansionary fiscal policy; this was especially important in getting the economy through the world economic recession in 2009, when the Brazilian economy shrank by just 0.65 percent. Increases in the minimum wage also helped to reduce poverty and inequality, as did the appreciation of the Brazilian currency. There was also an expansion of public investment and of credit.

But the appreciation of the currency has also hurt industrial and manufacturing competitiveness, and led to a rapid deterioration of the current account balance.

“Brazil is projected to have a $100 billion trade deficit in manufactured goods this year, up from $71 billion last year,” said Weisbrot. “This is partly the result of an overvalued currency, which has appreciated by 46 percent since the beginning of 2009.”

The authors put forth a number of possible policy changes that would allow for continued growth and progress in poverty reduction and income inequality, while keeping inflation under control.

“The fact that so many voices in the media are calling for cutting public spending, in order to slow the economy and thereby reduce inflation, shows that the debate over Brazilian macroeconomic policy is seriously misinformed,” said Weisbrot. “This debate needs to be broadened.”