Cyclical fluctuations in Brazil's real exchange rate : the role of domestic and external factors

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. Atemporary 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.