Financial Markets, External Shocks and Policy Responses: The Case of Brazil 2001

ABSTRACT This paper evaluates the macroeconomic response of the Brazilian government in 2001 following the emergence of sharp negative events in both the external and internal sectors with particular focus on monetary and exchange rate policies. It points out that the kind of macroeconomic reaction depicted by the standard Mundell-Fleming model is of little practical importance in a small open economy engulfed in dollar denominated debts and experiencing a confidence crisis like Brazil’s. The Brazilian economy operates as if there were some sorts of ceilings for the exchange rate and for interest rates, in a clear departure from the assumptions embodied in the “pure” model. In this kind of environment another set of actions is required to fight a dangerous exchange rate overshooting and that is proven by the events of 2001. Whilst the actions taken by the monetary authorities proved successful at that moment the paper shows that they came with sizeable real and financial costs as collateral. Therefore, the paper argues in favour of another set of macroeconomic responses which should have been preferred if we were to avoid such costs.