Price stabilization in Brazil: A classical interpretation for an indexed nominal interest rate economy

This dissertation is an attempt to interpret the high inflation process in Brazil and its later stabilization, according to the cost push approach instead of the traditional demand pull theory. It is argued that the dramatic deterioration in external financing conditions of Latin America in general, and Brazil in particular, triggered this episode of high inflation. Therefore, stabilization was attained when such external conditions changed in the 90's and policy makers were able to implement fixed exchange rate stabilization programs. Once stabilization plans were unsuccessfully implemented since the middle of the eighties, we criticize theoretically and empirically the elements that according to the conventional wisdom, explain the success and failure of stabilization plans in this period, presenting our explanation for both these failures and the success of the Real Plan in 1994. The events that unfold in the 80/90's were rather similar to the ones observed in Europe during the 20's and we trace this parallel stressing how illuminating to the understanding of the present can be this comparative study. However, there are also a few differences, the most important being the high degree of indexation of several nominal variables, specially the nominal interest rate. The latter becomes a crucial element to the mechanism we developed to explain both inflation and stabilization in Brazil. The nominal interest rate is the “bridge” between the firm's current costs and the replacement costs necessary to its future production. This difference, observed over the time, can be quite substantial in a high inflation environment and, therefore, very important to the firm's profitability. The use of the nominal interest rate as a causal element within a cost push type of model, is also fully compatible with the endogenous money approach since in the latter the most important theoretical tenet is the ability of the central bank to define unilaterally the interest rate. This work therefore applies the “balance of payments” theory of inflation adding some theoretical elements suggested by the stylized facts of a fully indexed economy.