Question

QUE // In a lengthy paper, discuss the role of fiscal and monetary policies in Brazil economy .

Answer 1

Monetary and fiscal institutions have played a decisive role in the stabilisation of the Brazilian economy since the mid-1990s. In Brazil institutional reforms were predominantly made in response to a succession of internal and, particularly, external crises. Brazil's experience of designing and managing institutions to this end is likely to be of interest to other emerging and low- or middle-income economies. As such, the Brazilian experience offers many lessons to be learned, both in the sense of what could be done and what is better avoided.

Recent facts have underscored the importance in evaluating the interaction between monetary and fiscal policies. Owing to the economic crisis in which the world was engulfed in 2007, governments mapped out strategies for the promotion of substantial fiscal incentives in an attempt to stave off an economic recession in their economies – including the Brazilian one – in the short run. Some of these countries are at a disadvantage because of their fast ageing population which, combined with fiscal incentives, warns against some strong fiscal pressure in the future. Fiscal pressure can cast some doubt upon the ability of the central bank to curb inflation and anchor inflation expectations, even if the bank follows an inflation target policy and is deeply committed towards these targets.

The lengths to which the monetary authority will go to control inflation depend on how monetary and fiscal policies are conducted, and thus, the concepts of fiscal dominance and monetary dominance take on added importance. The economy is under fiscal dominance when the fiscal authority independently determines the current and future budget, defining the share of revenues from bonds and seigniorage1 . This way, the monetary authority faces restrictions imposed by the demand for bonds issued by the government, having to finance the difference between the revenue demanded by the fiscal authority and the value of bonds sold to the public by means of the revenue obtained from the issuance of currency. Therefore, as the fiscal authority’s deficits cannot be financed only by the issuance of new bonds, the monetary authority may be coerced to issue currency and to put up with some inflation.

Even though the monetary authority gains some control over inflation, this control is less efficient than in an economy under monetary dominance. Analogously, an economy is under monetary dominance when the monetary authority defines its policy independently, determining the amount of revenue from the issuance of currency the fiscal authority will be entitled to if needed. In this case, the fiscal authority faces an additional restriction, given that any deficit in its budget must be financed by the combination of bonds sold to the public and the seigniorage determined by the monetary authority.

In the Brazilian economy, the conflict of interests between the Central Bank of Brazil and the National Treasury stresses the importance to assess the interaction between monetary and fiscal policies. The conflict arises from the distinct obligations of each of these organizations, which are directly bound to the same price in the economy: the interest rate.

The Central Bank of Brazil is in charge of price control in the economy. For this control, it uses the short-term interest rate as instrument, which constitutes a price that chiefly responds to changes in money supply. Thus, the bank utilizes money supply for domestic price stabilization. Therefore, its actions are somewhat free so that it can obtain the desired interest rate by applying the monetary policy.

The National Treasury is responsible for the management of both domestic and foreign public debt. This means that the National Treasury should seek to get the best financing deals for government’s operation, and best financing deals here should necessarily translate into a smaller debt value and longer maturity dates. To a certain degree, that is to say that the National Treasury is in charge of applying the fiscal policy.

Because the benchmark interest rate is applied to the government’s public debt, and the interest rate responds mainly to the central bank’s actions, the necessity of the bank to meet its obligations may be a major hindrance to the fulfillment of obligations by the National Treasury. As an example, in times of high inflationary pressure, the Central Bank tries to reduce money supply, which eventually pushes the interest rate up. In this case, the Central Bank’s action runs counter to the desires of the National Treasury

One of the most striking features of Brazilian monetary and fiscal history is its long period of high inflation pre-1994. We argue that the high degree of passiveness in monetary policy due to a weak institutional arrangement together with persistent and large fiscal deficits during that period, delivers a type of inflation persistence that goes a long way in accounting for these facts. In this section, we present a summary of the history of the Central Bank of Brazil, starting from the discussions surrounding its creation, and provide a description of how the government accessed seigniorage revenues. As will become clear, the Central Bank of Brazil was used many times to perform operations that are not consistent with the current notion of an autonomous monetary authority.

Before 1945, there was no clear separation between monetary and fiscal authorities, in the sense that the government Treasury had total control over money issuance. Rather, that was done through the Bank of Brazil, which held a monopoly over money issuance and operated in many instances as the bank of the government, as a commercial bank, and as a development bank. The debate surrounding the establishment of a central bank started before 1945, but it was only in that year when the first measures took place. The government created the Superintendency of Money and Credit (SUMOC), whose council had regulatory powers over the Central Bank of Brazil’s monetary affairs, and this SUMOC was supposed to serve as a stepping stone toward the creation of a central bank. However, the Bank of Brazil received the majority of seats on that council, which meant that, in practice, there was no disruption in the way monetary policy was conducted. Therefore, instead of establishing a central bank directly, Brazil opted for a two-step approach, in which the first step, SUMOC, lasted for twenty years. That process reflected a political impasse, with many interest groups reluctant to lose privileged access to subsidized credit, that is, their indirect access to money printing