1. Joaquin A. Cottani 13 November 2014 – Sao Paulo
Brazil’s Persistent Stagflation Is a Classic Case of “Unpleasant Monetarist Arithmetic”
Joaquin A. Cottani
13 November 2014 – Sao Paulo

2. Like many central banks in the world, the BCB relies on Inflation Targeting and the Taylor Rule to control inflation

3. However, the results have been mixed

4. Surprisingly, the periods in which consumer inflation was higher were also those in which GDP growth was lower

5. Conventional Explanations for Stagflation Puzzle
Potential growth has fallen so much in Brazil that even 1.7 percent actual growth is enough to produce demand-pull inflation.
Inflation stickiness is caused by the BCB’s perceived lack of independence and credibility, and the solution is for the BCB to rebuild its reputation by further tightening monetary policy until inflation converges to the target.
The interest rate is not so high when subsidized credit is taken into account.

6. Alternative Explanation: “Unpleasant Monetarist Arithmetic”
In Brazil, the Consolidated Federal Debt that includes the monetary liabilities of the Central Bank is 70% of GDP. Three fourths of this debt is held by commercial banks that transform it into liquid assets.
Liquid wealth (deposits + money-market funds) is an important determinant of private consumption.
The speed at which liquid wealth grows is influenced by the interest rate paid on government debt through the effect on budget deficit.

7. Brazil’s Financial Sector in Figures (billion BRL)

8. A Simplified Model Change in W = INT - S/W INF = Change in W – G
Suppose that:
Liquid Wealth = Public Debt = W
Nominal Interest Paid on Public Debt = INT
Primary Surplus = S
Potential Growth = G
Inflation = INF
Change in W = INT - S/W
INF = Change in W – G

9. What Causes Persistent Stagflation in Brazil?
Primary surplus (S) is below target due to political and institutional constraints.
BCB tries to compensate by raising INT.
“Sticky” INF causes INT-INF (real interest rate) to rise in short run reducing investment, hence potential growth (G).
Higher INT increases fiscal deficit making W grow faster.
Since G is supply determined, INF increases in the long run.
Conclusion: INF INT G

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