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The Brazilian Real under Krugman-Obstfeld DD-AA Model

I thought a simple but useful and complete analysis of the Brazilian economy under the DD-AA framework could help us understand the likely path of the Brazilian nominal exchange rate on a short to medium term horizon.

But why the DD-AA model? Well, we all studied the DD-AA model presented by International Economics: Theory and Policy, Paul R. Krugman and Maurice Obstfeld, so we are familiar with the assumptions and the ‘mechanics’ of the model. Moreover, we like the way the output market equilibrium and the asset market equilibrium combine to general equilibrium in the exchange rate market.

The question we want to ask is: Are really done in terms of BRL/USD appreciation or we still see fundamental behind further strengthening? Using the DD-AA framework one should be careful to analyze the changes (comparative statics) that will be taking place and not focus on what already happened. For this reason we look at the Brazilian economy in the way things are evolve from now till the end of this year to answer the implications in terms of nominal exchange rate.

1) The Output Market Equilibrium:

The DD-AA model is an open economy model capable of capturing the implications of changes in important fundamental variables such as real exchange rate, terms of trade and domestic demand changes (through policies or structural changes). Our output market equilibrium is basically described by the widely know identities:

Y = D (E.P*/P, Y-T, I, G) (1)

D = C(Y-T) + I + G + CA (E.P*/P, Y-T) (2)

Looking into each component of the aggregate demand equation (2) we can have a clue of how are things going to change from here to the end of the year. And here we see some ambiguity. Consumption is definitely going to post significant gain throughout the year as credit conditions remain quite favorable and the labor market continues to expand, increasing the wage bill and thus the overall disposable income of the economy. C ↑.

Even though we’ve seen some slight deceleration of investments in the 1Q08, as some proxies suggest (1Q08 GDP figures not out yet) we believe investments will continue to perform quite well and should be another component to push the aggregate demand to the upside. This is the case even considering a the COPOM’s interest rate hikes on the pipeline – business confidence remain strong and the Brazilian economy has been receiving a significant flow of foreign direct investment in addition to local initiatives. I ↑

It is quite difficult to affirm what is going to happen with government spending, not because it is a very volatile series but because there are many changes taking place at the same time. The CPMF taxes, the PAC development plan and also the increase in tax collection due to stronger domestic demand – let’s assume G is not a significant force driving aggregate demand up, but it neither a force driving it down. It’s a relatively reasonable assumption as we have not seen the government give any clear signs of cooperation towards a better balance between fiscal and monetary policy, which would require a more restrictive fiscal policy at the same time that we don’t see a spending spree taking place on the coming quarters.

On the current account, we see two forces playing on the same direction. First force is the real exchange rate appreciation, while the second is the real disposable income gains. BCB’s real effective exchange rate series shows an appreciation of 11.4% y/y during the 1Q08 and we should expect more real appreciation this year as Brazil’s terms of trade improve due to the overall bull market in commodities. As discussed before, abundance of credit and labor market advances should also guarantee higher disposable income for Brazilians to buy from abroad. Therefore, we should see a deterioration of the current account due to higher demand for imported goods and services as a result of both stronger income and stronger real exchange rate. Meanwhile, we should also mention that exports of goods and services might fall in the same way as the real exchange rate appreciates and overall rest-of-the-world income declines. CA ↓.

As we know, the importance of private consumption and private investment account for nearly 80% of the aggregate demand, while net exports or the current account have a weight of only 3.5% on the AD. Therefore, the external

channel of the aggregate demand is quite timid vis-à-vis the importance of consumption and investment. Therefore, the aggregate demand is certainly shifting upwards. On our DD-AA framework, this means the DD curve is shifting to the right, where for the same output we have a stronger nominal exchange rate. For more details on the model click here

2) The Asset Market Equilibrium

The asset market equilibrium is based on two conditions: The interest rate parity equilibrium and the real money market equilibrium. They follow

R = R* + (Ee – E)/E (3)

MS/P = L (R, Y) (4)

We should say that the asset market equilibrium is much faster to adjust and at any given point it will only change once expectations change. Therefore, we see the asset market equilibrium shifting throughout the year as expectations of (R – R*) changes or as (Ee – E)/E changes and so forth. Our assumption is that different forces will play simultaneously but the end result is not too far from the current equilibrium. Therefore, the asset market equilibrium may not shift dramatically and thus the AA curve should remain unchanged, if not a little biased to a leftward shift. For details on the DD-AA diagram click here.

3) Flow Does Not Determine the Path of the FX

Very quickly comment on this. Foreign exchange flows are just the result of shifting economic fundamentals. The currency path reacts to developments on both output and asset markets, but not to the flow of USD. The flow is a reaction to changes in private consumption, private investment, fiscal policy, interest rate differentials, expected

future exchange rate, level of prices or inflation, inflation expectations and etc… Therefore, despite all the comments on strong FDI, strong portfolio flows are just reflecting what goes on in the economy. Should not be double-counted! But this doesn’t mean the strength of the financial accounts of the balance of payments is not worth looking at and should not determine the strength of the BRL. It only means that by an economic fundamental perspective, those flows are just a consequence of the stronger private consumption, strong investment and the overall resilience of the domestic demand.

4) Conclusion

We see many risks of further appreciation of the BRL through the end of this year. In case we see a better than expected GDP growth on the coming quarters, more and more pressure towards a stronger nominal rate should arise. I forecast a 1Q08 GDP growth of 6.4% y/y quite strong basically in response to very robust private consumption and still strong private investment. The moderate way private consumption and investment should respond to higher domestic rates should surprise. In this sense it is very likely that we see a GDP growth closer to 5.0% or higher in 2008, above consensus of 4.5%. Another key factor is the BCB’s response to local inflation. In case the IPCA inflation shows signs of persistency, the BCB may well increase rates, increasing interest differentials, adding more strength to the real. In addition to it, an abrupt rebound in risk appetite in combination with renewed episodes of upside-down currency attacks could affect expected changes in the currency (Ee – E)/E and thus add even more strength to the Brazilian real.

Italo T. Lombardi

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