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The Long-term

Discussion paper by Nassif, André; Feijó, Carmem; Araújo, Eliane, 2011

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Using the structuralist-Keynesian theoretical approach, the paper affirms that, instead of macroeconomic fundamentals, the long-term trend of the real exchange rate level should not only be determined by structural forces and long-term economic policies, but also short-term macroeconomic policies and their indirect effects on other short-term economic variables. It also proposes an original concept of a long-term “optimal” real exchange rate for open emerging economies.

No. 206


December 2011


THE LONG-TERM "OPTIMAL" REAL EXCHANGE RATE


AND THE CURRENCY OVERVALUATION TREND


IN OPEN EMERGING ECONOMIES:


THE CASE OF BRAZIL






THE LONG-TERM “OPTIMAL” REAL EXCHANGE RATE
AND THE CURRENCY OVERVALUATION TREND


IN OPEN EMERGING ECONOMIES:
THE CASE OF BRAZIL


André Nassif, Carmem Feijó and Eliane Araújo


No. 206
December 2011


Acknowledgements: The opinions expressed in this study are those of the authors and do not reflect the views
of the Brazilian Government, the BNDES and UNCTAD. This paper has been presented at the following
conferences: the 5th Post-Keynesian Conference at Roskilde University (Roskilde, Denmark, 13–14 May 2011),
the 8th International Conference Developments in Economic Theory and Policy (Bilbao, Spain, 29 June–1 July
2011), the 4th International Congress of the Brazilian Keynesian Association (Rio de Janeiro, Brazil, 3–5 August
2011) and the 15th Conference of the Research Network Macroeconomics and Macroeconomic Policies at the
Macroeconomic Policy Institute (IMK) at the Hans-Boeckler-Foundation (Berlin, Germany, 27–29 October 2011).
The authors are highly indebted to Annina Kaltenbrunner, Luiz Carlos Bresser-Pereira and Francisco Eduardo
Pires de Souza, who carefully read an earlier manuscript and provided comments and advice which we believe
have significantly improved our theoretical and empirical approach. We are also grateful to Antônio Delfim Netto,
Fábio Giambiagi, Ugo Panizza, Nelson Marconi, Paulo Gala, Julio Lopez, Cláudio Leal, Alexandre Sarquis, Victor
Pina Dias, Roberto Meurer, Bruno Feijó and an UNCTAD´s anonymous referee for additional suggestions to this
final version. The remaining errors are the authors’ responsibility.


UNCTAD/OSG/DP/2011/6




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The opinions expressed in this paper are those of the authors and are not to be taken as the official views
of the UNCTAD Secretariat or its Member States. The designations and terminology employed are also
those of the authors.


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Comments on this paper are invited and may be addressed to the authors, c/o the Publications Assistant,
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New Discussion Papers are available on the UNCTAD website at http://www.unctad.org.


JEL classification: F30, F31, F39




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Contents


Page


Abstract ...................................................................................................................................................... 1


I. INTRODUCTION ................................................................................................................................ 1


II. FLOATING EXCHANGE RATES REGIME AND FREE CAPITAL MOVEMENTS:
ECONOMIC POLICY DILEMMAS FOR EMERGING ECONOMIES ...................................... 3
A. The “impossible trinity” and issues for emerging economies ........................................................... 3


III. THEORETICAL DETERMINANTS OF THE REAL EXCHANGE RATE:
STRUCTURAL AND SHORT-TERM VARIABLES ........................................................................ 5


IV. REAL EXCHANGE RATE OVERVALUATION: EMPIRICAL EVIDENCE
FOR BRAZIL IN THE 2000s .............................................................................................................. 8
A. Econometric implementation ............................................................................................................ 9
B. The long-term trend and the long-term “optimal” real exchange rate in Brazil ............................. 14


V. CONCLUDING REMARKS AND ECONOMIC POLICY IMPLICATIONS ............................ 16


Annex 1 .................................................................................................................................................... 19
Annex 2 .................................................................................................................................................... 19
Annex 3 .................................................................................................................................................... 21


REFERENCES ........................................................................................................................................... 22


List of tables
1 Johansen test of cointegration rank ...................................................................................................... 11
2 Estimated model for Brazil; dependent variable: real exchange rate ................................................... 12
A.1 Unity root tests in the residuals ............................................................................................................ 19
A.2 Augmented Dickey-Fuller test (ADF): in levels and first differences ................................................. 20
A.3 Phillips-Perron test (PP): in levels and first differences ....................................................................... 20


List of figures


1 Actual real effective exchange rate, Brazil, February 1999–February 2011 .......................................... 9
2 Actual and long-term estimated real exchange rates in Brazil, February 1999–February 2011 .......... 14
3 Level of undervaluation or overvaluation of the actual real exchange rate related to
the long-term estimated trend, February 1999–February 2011 ............................................................ 15






THE LONG-TERM “OPTIMAL” REAL EXCHANGE RATE
AND THE CURRENCY OVERVALUATION TREND


IN OPEN EMERGING ECONOMIES:
THE CASE OF BRAZIL


André Nassif,* Carmem Feijó** and Eliane Araújo***


Abstract


We present a Structuralist-Keynesian theoretical approach on the determinants of the real exchange
rate (RER) for open emerging economies. Instead of macroeconomic fundamentals, the long-term
trend of the real exchange rate level is better determined not only by structural forces and long-term
economic policies, but also by both short-term macroeconomic policies and their indirect effects on
other short-term economic variables. In our theoretical model, the actual real exchange rate is broken
down into long-term structural and short-term components, both of which may be responsible for
deviations of that actual variable from its long-term trend level. We also propose an original concept
of a long-term “optimal” real exchange rate for open emerging economies. The econometric models
for the Brazilian economy in the 1999–2011 period show that, among the structural variables, the GDP
per capita and the terms of trade had the largest estimated coefficients correlated with the long-term
trend of the RER in Brazil. As to our variables influenced by the short-term economic policies, the
short-term interest rate differential and the stock of international reserves reveal the largest estimated
coefficients correlated with the long-term trend of our explained variable. The econometric results
show two basic conclusions: first, the Brazilian currency was persistently overvalued throughout
almost all of the period under analysis; and second, the long-term “optimal” real exchange rate was
reached in 2004. According to our estimation, in April 2011, the real overvaluation of the Brazilian
currency in relation to the long-term “optimal” level was around 80 per cent. These findings lead
us to suggest in the conclusion that a mix of policy instruments should have been used in order to
reverse the overvaluation trend of the Brazilian real exchange rate, including a target for reaching
the “optimal” real exchange rate in the medium and the long-run.


I. INTRODUCTION


One of the most controversial topics in recent economic literature concerns the determinants of the
real exchange rate (RER). At least two alternative theories dispute arguments on how to establish the
long-term RER: the more traditional theory of purchasing power parity (PPP) and Williamson’s (1983)
alternative concept of the real exchange rate denoted by the fundamental equilibrium exchange rate
(FEER). Nonetheless, in spite of the lack of theoretical consensus on how to determine the real exchange
rate, empirical literature has shown that exchange rate overvaluation has negative effects on long-term


* Fluminense Federal University (Universidade Federal Fluminense) and The Brazilian Development Bank (BNDES),
Rio de Janeiro, Brazil; andrenassif@bndes.gov.br; al-nassif@uol.com.br.


** Fluminense Federal University, Rio de Janeiro, Brazil; cfeijo@terra.com.br.
*** State University of Maringá (Universidade Estadual de Maringá), Paraná, Brazil; elianedearaújo@gmail.com.




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economic growth (Razin and Collins, 1999; Dollar and Kraay, 2003; Prasad, Rajan and Subramanian,
2006; Gala, 2008). Rodrik (2008) and Berg and Miao (2010) went further and showed empirical evidence
that not only does overvaluation damage growth, but also that undervaluation benefits growth. Also,
Williamson (2008) suggests that “the very best policy (in terms of maximizing growth) appears to be a
small undervaluation” (p. 14, italics from the original) and concludes: “The evidence that overvaluation
hurts development is now sufficiently strong to merit being reflected in policy, including delay to capital
account liberalization where it appears likely to threaten overvaluation” (p. 24).


Yet, one of the main implications of the Mundell-Fleming model is that small economies under a floating
exchange rate regime and free capital mobility face greater volatility in their nominal exchange rates.
Indeed, since nominal exchange rates are highly volatile over short periods and nominal prices are rigid,
there is evidence that nominal and real exchange rates are correlated almost one to one in the short-term
(Flood and Rose, 1995). As Aizenman, Chinn and Ito (2010) show, emerging Asian countries have been
relatively successful in reducing the high volatility of their nominal exchange rate by purchasing large
amounts of international reserves. However, the room to manoeuvre in this area is very limited in Brazil
because, due to continuing high interest rates, the cost of sterilizing the monetary impact of purchasing
international reserves by the Central Bank has negative impacts on gross public debt.


The Brazilian currency, in particular, has shown a trend of real overvaluation since inflation was controlled
in the mid-1990s. After 2004, this trend became stronger, and it has intensified since the aftermath of
the 2008 international financial crisis, given the increase in capital flows from advanced economies into
fast growing emerging economies. This trend has only been interrupted by either internal or external
shocks. In this sense, the foreign scenario of increased capital volatility in a financially integrated world
exacerbates the trilemma of economic policy for Brazilian policy-makers, that is to say, the difficulty of
balancing the competing objectives of economic policy: price stability, exchange rate stability and free
capital mobility.


To shed some light on how to reach the mix of policies that would allow for an improvement in policy
space in emerging economies, our aim in this paper is to present a Structuralist-Keynesian approach in
which the real exchange rate, instead of being explained by macroeconomic fundamentals linked basically
to market forces, is better explained by not only long-term structural forces like market competition
but also short-term economic policies. We also present an econometric model that captures the main
explanatory variables of the real exchange rate in Brazil in the 2000s. In our empirical model, which
covers the 1999–2011 period and uses monthly data in the econometric implementation, the policy space
can be inferred from the importance that each group of variables – either those linked to the structural
functioning of the economy, or those related to short-term economic policies – has in explaining the real
exchange rate.


We also introduce an original concept of long-term “optimal” real exchange rate. As far as we know, this
concept has not been raised before in international economics. This new theoretical concept is used to refer
not to a long-term equilibrium real exchange rate as disseminated by the conventional theoretical literature
on the subject (such as PPP theory, for instance), but rather to a long-term reference real exchange rate
which is able to reallocate the productive resources towards the sectors with the highest productivity and,
considering everything else equal, directs the economy as a whole towards technological and economic
catching-up in the long run. In accordance to the empirical evidence on the relationship between the real
exchange rate and growth for open emerging economies, the long-term “optimal” level for the RER must
incorporate a small undervaluation. We will argue ahead that the “optimal” level might (and should) be,
at least partially, targeted.


The remainder of the paper is organized as follows: section II analyses the economic policy dilemmas
that policy-makers in emerging economies have to face to avoid large real exchange rate deviations
from their long-term “optimal” level in an economy with a floating exchange rate regime and free
capital mobility. Section III briefly discusses the theory of the determination of a real exchange rate and




3


proposes a Structuralist-Keynesian theoretical model that better explains the determinants that cause the
actual real exchange rate to deviate from its long-term “optimal” level in open emerging economies, like
Brazil. Section IV presents the econometric evidence for Brazil in the 2000s. Section V draws the main
conclusions and discusses some policy implications for Brazil.


II. FLOATING EXCHANGE RATES REGIME AND FREE CAPITAL MOVEMENTS:
ECONOMIC POLICY DILEMMAS FOR EMERGING ECONOMIES


In open financially integrated economies, the exchange rate plays a fundamental role in macroeconomic
policy as its level and volatility affect not only inflation, but also the balance of payments, investment
decisions and economic growth. Economic literature on growth suggests that, unless the so called Harrod-
Balassa-Samuelson effect is considered, continuous real overvaluation of the exchange rate does not
favour economic growth. Given this assumption, this section provides analytical arguments to further
investigate which mix of short-term economic policies could favour growth strategies with exchange
rate stability. Our theoretical concern is directed to emerging economies that face greater difficulty in
the macroeconomic adjustment of the exchange rate, given their higher vulnerability to the external
movement of capital flows.


A. The “impossible trinity” and issues for emerging economies


Nowadays, most emerging countries adopt a floating exchange rate regime. The theoretical literature
suggests that, under a system of flexible exchange rates, both the autonomy of monetary policy and low
volatility of interest rates could be assured, because this policy instrument could not be used to stabilize
the exchange rate. In practical terms, however, given the great financial integration among economies,
monetary autonomy is not observed (Greenville, 1998). In addition, the recent international experience
has shown that emerging countries actually intervene in their foreign exchange market in order to offset
violent movements in the exchange rate, configuring an intermediary floating exchange rate regime.
Actually, central banks interfere in the foreign exchange market every time they choose to reach a
macroeconomic goal. The success of such interventions in reducing exchange rate volatility or eliminating
the misalignment (especially overvaluation) can be evaluated according to the policy space that monetary
authorities have to implement counter-cyclical measures aimed at increasing output and employment
while reducing external vulnerability. This space is reduced when short-term economic policy has to be
used to restore the equilibrium of the balance of payments (Ocampo and Vos, 2006).


By discussing how some emerging Asian countries have tried to reduce high volatility of their nominal
exchange rate, Aizenman et al. (2010: 2) argue that “a country may simultaneously choose any two, but not
all, of the following three goals: monetary independence, exchange rate stability and financial integration.
This argument, if valid, is supposed to constrain policy makers by forcing them to choose only two out
of the three policy choices.” In this sense, they present the trilemma of economic policy that implies the
choice of a mix of possibilities among different degrees of autonomy of monetary policy, foreign exchange
intervention and capital mobility. However, Aizenman et al. showed sound econometric evidence that,
since the Asian crisis of 1997, most Asian countries (except China), even without giving up a floating
exchange rate regime and freedom of capital movements, have been very successful in by-passing the
“impossible trinity” through an aggressive policy of accumulation of international reserves. In other words,
rather than a dirty floating exchange rate regime like most Latin American countries (including Brazil),
the Asian countries have, in practical terms, an administered floating exchange rate regime.


The logic of the Mundell-Fleming model states that the choice of the exchange rate regime has implications
on how domestic prices and the balance of payments are kept in equilibrium. However, Mundell (1960)
had already observed that, since the internal stability of a model with a floating exchange rate and capital
mobility depends on the manipulation of the interest rate, this latter instrument affects the stability of




4


domestic prices in an indirect way. The change in the interest rate aimed at controlling aggregate demand
affects, first, the short-term capital flow, which in turn affects, albeit with some time lag, the exchange
rate which, in turn again, is adjusted to restore the equilibrium in the market of goods and services as
well as the balance of payments. In this way, in economies that are open to free capital movements, the
transmission mechanism of the monetary policy operates through the exchange rate.1 This occurs because
the sensitivity of the adjustment in the market of goods and services is inferior to the sensitivity of the
changes in the capital movements to the interest rate.


Moreover, since many emerging economies are characterized by some specificities such as non-convertible
currencies, high volatility in the capital flows as well as recurring and persistent current account deficits,
their operation of a floating exchange rate regime is often associated with high volatility in the nominal
exchange rate, which leads to systematic interventions in the foreign exchange market. These interventions
can be justified as a defensive measure to respond to the greater sensitivity that emerging economies
have when it comes to external shocks and does not necessarily mean a “fear of floating”, as Calvo and
Reinhart (2002) argued.2


In fact, particularly in the case of Brazil, the “fear-of-floating” argument seems to be misleading when
it comes to explaining the large positive difference between domestic and external interest rates. As
Silva and Vernengo (2009) argue, since the inflation rate target regime was introduced in Brazil in 1999,
Brazil’s Central Bank has managed the monetary policy in a very conservative way.3 In practical terms,
its only goal has been to keep inflation rates low and very close to target. The authors conclude that,
in the case of Brazil, rather than a “fear-of-floating” behaviour, Brazil’s Central Bank has presented a
“fear-of-inflating” behaviour, meaning that this assumption would better explain the very high short-term
interest rate differential.


Given the considerations above, two stylized facts that narrow the policy space of economic authorities
in emerging countries can be formulated:


1. Unstable expectations in relation to the exchange rate contribute to exchange rate appreciation in
emerging economies


The uncovered interest rate parity (i= i*+ ee) determines that the domestic interest rate, i, is equal to the
international rate, i*, plus the expectation of exchange rate depreciation, ee. This latter variable, in turn,
is affected by many factors, especially by the country’s risk premium. Thus, when the country’s risk
premium increases, the domestic currency is expected to depreciate (ee>0).4 This means, on the one hand,
if high instability in the foreign exchange market is observed, the threat of depreciation puts pressure on
the domestic interest rate to keep domestic assets attractive. This suggests a positive correlation between
the short-term interest rate differential and the nominal (and real) exchange rate.


1 For specific transmission channels of monetary policy in emerging economies, see Bhattacharya et al. (2011). They
found strong evidence that the exchange rate is the main transmission channel for monetary policy in India.
2 Consistent with the uncovered interest rate hypothesis, this would suggest a positive correlation between expectations
of exchange rate depreciation and an increase in the domestic interest rate, in the assumption that the international interest
rate remains unchanged.
3 As an example of the conservative manner in which Brazil’s Central Bank manages the monetary policy, after the
outburst of the global financial crisis in September 2008, Brazil’s basic interest rate (SELIC) was maintained at 13.75 per
cent p.a. until January 2009, even taking into account the recessionary environment in Brazil. See Nassif (2010) for a
comparative analysis between India and Brazil about this issue.
4 The uncovered interest rate parity can also be expressed as i = i* + ee + CR, where CR is the country’s risk premium
(Rivera-Batiz and Rivera-Batiz, 1994). This expression makes it clearer that the final impact of an unexpected increase
in the country’s risk premium (e.g., following an external shock) is, through its effect on the expectations for domestic
currency depreciation, to augment the domestic interest rate.




5


On the other hand, as soon as the foreign exchange market is stabilized again, an appreciation of the
exchange rate is expected in response to the manipulation of the domestic interest rate by the central
bank to avoid currency depreciation. The systematic increase in the short-term interest rate differential
represents an additional incentive to sustain the exceeding flows of foreign short-term capital, especially
those of a speculative nature. In practical terms, according to this stylized fact, since foreign investors tend
to bet on the appreciation trend of currencies in emerging economies in the near future, the use of these
currencies for carry-trade strategies implies that the uncovered interest rate parity is explicitly violated in
the short term. That is to say, instead of reflecting expectations of depreciation, this fact reveals that the
higher the interest rate differential, the greater the expectation that the domestic currency will continue
to appreciate. So, in this case, the effect of an increase in the interest rate differential on exchange rate
appreciation occurs with some time lag due to the attractiveness of large short-term capital inflows.
This tendency will only be interrupted by sudden stops.5 The trend in favour of over-valuating the real
exchange rate has also been pointed out by Obstfeld (2008). According to the author, taking into account
the short-term nominal price rigidities, another collateral effect of the floating exchange rate regime with
free capital mobility in emerging economies is that changes in worldwide demand for assets or domestic
products are quickly translated into an overvaluation of the real exchange rate.


2. Excess of international liquidity pushes foreign capital towards open emerging economies and
deteriorates gross public debt


When international liquidity is plentiful and the inflow of foreign capital exceeds the necessity to finance
balance of payments equilibrium, foreign reserves will increase. This increase, given the interest rates
differential, implies financial loss for the country, on one hand, and an increase in the gross public debt,
on the other, that is equal to the part of the reserve that has been sterilized. This means policy-makers face
a trade-off between purchasing international reserves to avoid a large real overvaluation of their currency
and, since they have to sterilize the monetary impacts of that policy, absorbing this extra burden on gross
public debt. The foreign reserve accumulation policy could also aim at building a net safety to prevent
negative consequences in capital inflows in the long-term. Nonetheless, this policy has a clear negative
impact on domestic fiscal policy. Also, it should be noted that the increase in the gross public debt has a
negative effect on the country’s risk premium. In this case, the assumption is that a higher gross public
debt/GDP ratio increases expectations of exchange rate depreciation, which in turn puts pressure on the
domestic interest rate.


III. THEORETICAL DETERMINANTS OF THE REAL EXCHANGE RATE:
STRUCTURAL AND SHORT-TERM VARIABLES


At least two theories compete to offer the most convincing hypothesis that explains both the determinants
of the real exchange rate equilibrium in the long-term and the causes of deviations of this trend in the very
short term: the theories of purchasing power parity (PPP), and the fundamental equilibrium exchange rate
(FEER). The PPP theory, which defines the real exchange rate as the relative price of a common basket
of goods traded between two countries converted into the same numeraire, predicts that in an ideal world
without any nominal price rigidity, transport costs, trade barriers or other short-term disturbance, that
ratio should be equal to 1. Since the hypothesis under the absolute version of the PPP theory is difficult
to hold, the relative version of the PPP theory is more accepted, and it can be defined as (all variables
in logarithms):


RER = e – (p – p*) (1)


where: RER is the real exchange rate;


5 On the use of the Brazilian currency (the real) in carry-trade strategies over the last few years, see Kaltenbrunner (2010).




6


e is the nominal exchange rate (defined as the domestic currency price of foreign currency);
p and p* are the domestic and foreign price levels, respectively.


This definition implies that a fall in both nominal and real exchange rates is an appreciation. In a study on
the PPP theory, Taylor and Taylor (2004) showed that there is now (more than in the past) sound evidence
that the PPP remains valid in the long run. However, they also stressed that empirical studies have shown
a strong reversion of the real exchange rate equilibrium over time. Therefore, for an econometric study
not to show a biased result, it is important to incorporate variables that can capture structural changes in
the economy, such as the so-called Harrod-Balassa-Samuelson effect and the terms of trade.


The former refers to a tendency of a country that shows higher changes in productivity of tradable goods
compared with non-tradable ones relative to the world economy to have higher price levels, that is to
say, a real exchange rate appreciation. As Obstfeld and Rogoff (1996) concluded “the famous prediction
of the Harrod-Balassa-Samuelson proposition is that price levels tend to rise (that is, the real exchange
rate over time tends to appreciate) with country per capita income”.


The terms of trade (ToT) is another important variable associated with changes in the long-term structural
behaviour of the real exchange rate. According to Baffes et al. (1999: 413) “an improvement in the terms
of trade increases national income measured in imported goods; this exerts a pure spending effect that
raises the demand for all goods and appreciates the real exchange rate”.6 Edwards (1989) comments that
most authors are used to establishing a negative relationship between the ToT and the real exchange rate.
He also agrees that an improvement in the terms of trade, by augmenting the real income, results, in fact,
in an increasing of the demand for non-tradable goods and, therefore, in a real exchange rate appreciation.
However, Edwards (1989: 38) emphasizes that “a problem with this view is that the income effect is only
part of the story (…) and both income and substitution effects, as well as intertemporal ramifications,
should be analysed”. In other words, if the net income effect of an improvement of the ToT on the RER
is positive, there will be a real exchange rate appreciation. This tends to be the immediate effect of the
improvement in the ToT on the RER. However, after some time, the initial increase of the real income
provoked by favourable ToT might be followed by replacement of the non-tradable goods for tradable
ones. If this is the case, the substitution effect will prevail on the income effect and, given the increase
of the relative prices of tradable goods, the impact on the RER will be depreciation. In other words, the
expected effect of the ToT on the RER is ambiguous.


The FEER theory, on the other hand, was proposed by Williamson (1983) to connect either the medium or
the long-term equilibrium real exchange rate (the so-called fundamental one) with the current economic
policy. It should be considered that both PPP and FEER theories were developed within the mainstream
framework of the determination of the real exchange rate. In both approaches, the role of economic
fundamentals is essential for explaining the movements of the real exchange rate in the long run. However,
the forces that deviate the real exchange rate from its “fundamental” long-term equilibrium are explained
by either very short-term price rigidity or monetary and real shocks, or any other market disturbances.


Although a heterodox approach is not discussed in international economics textbooks, there has been
some effort to propose an alternative theoretical framework in both Structuralist and Keynesian literature.
In the first line of research, Bresser-Pereira (2010) proposes a Structuralist approach to explain that in a


6 For a formal treatment, see Obstfeld and Rogoff (1996).




7


world with floating exchange rate regimes and high freedom of capital movements, currencies of emerging
economies have a chronic tendency to overvalue rather than undervalue.7


Bresser-Pereira (2010) classifies his approach as Structuralist because this tendency to overvalue is driven
by one (or both) of the following two structural forces:


(i) the Dutch disease, which makes countries rich in natural resources to chronically overvalue their
currencies in real terms; and


(ii) the attractive power with which countries scarce in capital absorb large amounts of short-term
capital inflows.


The author does not reject the existence of an equilibrium real exchange rate, but, different from the
mainstream approach where there is only one equilibrium real exchange rate, Bresser-Pereira’s hypothesis
opens room for the existence of two equilibrium real exchange rates: “an industrial equilibrium” exchange
rate which could move the economy towards the international technological frontier and a trajectory of
faster economic development, and, in the case of those countries which suffer from the Dutch disease,
“a current equilibrium”, that is, an exchange rate that tends to overvalue as it deviates the economy from
the technological path consistent with economic development (Bresser-Pereira, 2010: chapter 4). As long
as the real exchange rate appreciation movement persists, both structural forces and inconsistent short-
term economic policies end up driving the economy to generate increasing current account deficits that
will only be adjusted by a balance of payments crisis and a disruptive overshooting of the nominal and
real exchange rate.


In normative terms, Bresser-Pereira and Gala (2010: 25) argue that while for “the conventional wisdom,
exchange rate policy must be flexible in such a way that monetary authorities should have neither a goal
nor a policy for the exchange rate”, for the Structuralist view in a world relatively open to capital flows,
“although the exchange rate regime must be flexible, the Central Bank should (and must) pursue the so-
called industrial equilibrium exchange rate”.


Another alternative view on the determination of the real exchange rate behaviour is offered by the
Keynesian literature. Considering that there is no economic forces strong enough to guarantee that an
economy will move towards equilibrium positions in the long- term (the long-term is the sum of a sequence
of short-term events), the Keynesian theory rejects the distinction between long-term and short-term
equilibrium exchange rates.8 Following this, even knowing that the Keynesian literature on the theme
is very scarce, Kaltenbrunner (2008) argues that, instead of market forces driven by fundamentals, real
exchange rates are essentially explained by short-term capital flows.


As a matter of fact, Keynes (1923) had already recognized that short-term capital flows are one of the
main transmission channels of interest rates differential between countries and exchange rate movements.
However, rather than believing that this relationship would be based on the traditional uncovered interest
rate parity, Keynes emphasized the role of the agents’ forecast confidence (Harvey, 2006). As Harvey
(2006: 397) states:


... the uncovered interest rate parity deviation is a forecast, and forecasts are never certain. In general,
the more confidence agents have in their predictions, the more funds they are willing to commit in


7 In an e-mail sent to one of the authors of this paper, Professor Bresser-Pereira argued that the term “misalignment” is
misleading when referring to the actual level of the real exchange rates of these economies, for the general tendency is to
overvalue. In other words, “misalignment” would be a shadow term for overvaluation. As will be shown ahead, instead
of “misalignment”, we will use the expression “deviation of the actual real exchange rate from its long-term trend level”
and will also estimate, in turn, the long-term “optimal” real exchange rate for the Brazilian economy.
8 This does not mean that the Keynesian approach rejects the existence of an “optimal” real exchange rate, but that this
indicator is essentially determined and influenced by economic policies.




8


speculation. The more realistic way to incorporate this into this model would be to make capital flows
(for a given uncovered interest rate parity deviation) go from a trickle to a strong flow as forecast
confidence increased.


Similar to both Structuralist and Keynesian literature on the theme, we propose a model that rejects the
long-term variables determined by “fundamental” forces as required by the PPP and FEER theories.
In our Structuralist-Keynesian theoretical framework, we consider two groups of variables: the first
expresses long-term structural forces; and the second represents a set of variables directly or indirectly
influenced by short-term economic policies. Differently from the conventional theoretical approaches,
in the Structuralist-Keynesian model proposed here, not only the long-term trend of the real exchange
rate, but also the deviations of the actual real exchange rate from an “optimal” level are jointly explained
by long-term structural forces and short-term economic policies.9 Moreover, we reject the conventional
wisdom of the existence of automatic forces driving the real exchange rate either towards a long-term
equilibrium (such as the PPP approach) or even a long-term “optimal” level (as inherent in our framework).
By supporting this argument, our model is expressed as:


(2)


where RERt is the actual real exchange rate and the variables that comprise the function g are interpreted
as representing the long-term structural forces denoted by structltt which are better driven by both market
competition and long-term economic policies,10 and the component m incorporates the set of short-term
variables stt that are directly and indirectly influenced by short-term macroeconomic policies. In fact,
both structural and short-term economic policies may be responsible for not only driving the long-term
real exchange rate towards its “optimal” trend, but also (depending on the specificity of the structural
force and the quality of the short-term economic policy) directing that indicator to a “suboptimal” level.
The main policy implication of our model is that, like most Asian countries, policy-makers could (and
should) target, at least partially, the real exchange rate in such a way that it could be driven towards a
long-term “optimal” level.


When the theoretical model is expressed in econometric specifications (section IV), we cannot only capture
the main determinants of the recent actual real overvaluation of the Brazilian currency, but also evaluate
the policy space of short-term economic policies, according to the explanatory power of the m variables.
Despite the fact that our model does not capture important characteristics related to the workings of
foreign exchange markets, such as the dynamic changes and the forward-looking behaviour, its simplicity
is attractive enough to provide a useful and comprehensive empirical implementation.


IV. REAL EXCHANGE RATE OVERVALUATION: EMPIRICAL EVIDENCE
FOR BRAZIL IN THE 2000s


The Brazilian currency has presented a trend towards overvaluation of its real exchange rate ever since
inflation became controlled in the mid-1990s. The phase of the floating exchange rate regime (from
January 1999 on), which was followed by the adoption of an inflation targeting regime, did not bring
stability to the real exchange rate. After 2004, the trend towards real appreciation of the Brazilian currency,
the real, became for the majority of the time a dominant pattern until the eruption of the international


9 See Razin (1996) and Razin and Collins (1999) for a conventional theoretical and empirical formulation.
10 By long-term economic policies, we mean those government measures which are introduced with the objective of
accelerating structural change and economic development, such as industrial and technological policies, trade policies and
so on. In this sense, although it is hard to reject that the productivity change is one of the most important structural forces
behind the long-term real exchange rate, we must stress that the evolution of productivity is in itself strongly influenced
by those kinds of the above-mentioned long-term economic policies.




9


financial crisis in September 2008. After a sharp depreciation during the aftermath of the financial crisis,
the appreciation trend of the Brazilian real has intensified again.


Figure 1 shows the evolution of the real exchange rate from February 1999 to February 2011. Considering
the standard deviations of the real exchange rate, figure 1 shows three distinct phases related to the
trajectory of the RER. The first phase (standard deviation of 6.7) begins in the months immediately after
the change in the Brazilian exchange rate regime. After a sharp depreciation of the real exchange rate
at the end of 1998, the introduction of a floating exchange rate regime in early 1999 was followed by a
relatively stable evolution in 2000.


Figure 1


ACTUAL REAL EFFECTIVE EXCHANGE RATE, BRAZIL, FEBRUARY 1999–FEBRUARY 2011
(Monthly data, 2000 average real exchange rate = 100)


Source: Brazil’s Central Bank.


After this short period of relative stability, the second phase (standard deviation of 16.8) was marked
by the negative expectations of the presidential election of a candidate (Luiz Inácio Lula da Silva), who
was at the time adversely evaluated by markets in Brazil. The Brazilian currency, in this second phase,
showed a trend towards depreciation in real terms until mid-2004.


Throughout the third phase (standard deviation of 18.0), from June 2004 onwards, the real exchange
rate showed an appreciation trend, except for the second half of 2008, when the international financial
crisis triggered a brief movement of depreciation of the Brazilian currency. In this phase, the Brazilian
economy was characterized by greater dynamism. In fact, the expansion of world trade, mainly after
2004, favoured the country’s terms of trade, allowing the growth and real appreciation of its currency to
occur simultaneously.11 In addition, in absence of capital controls, the excess inflow of external capital
forced the Brazilian real to appreciate.


A. Econometric implementation


Our theoretical framework presented in equation (2) will be translated into the following econometric
specification (equation 3):


11 Real GDP grew at 5.7 per cent in 2004; 3.2 per cent in 2005; 4.0 per cent in 2006; 6.1 per cent in 2007; and 5.1 per
cent in 2008.


60


80


100


120


140


160


180


1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011


Relative
stabiltiy


Real appreciation
trend


Phase 3Phase 2


Real depreciation
trend


Phase 1




10


tttttt


tttt


CRIRSTKFIDIFERIDIFER
CAToTYcRER


εβββββ
ααα


++++++
++++=


− lnlnln)(ln)(ln
lnlnlnln


543121


3210
(3)


Following analogous procedures of empirical literature on the real exchange rate determination, we chose
the most appropriate candidates to represent the variables associated with the structural changes in the
real exchange rate in the long run (variables with the α coefficients on the right hand of equation (3))
and those directly or indirectly associated with the short-term policies (variables with the ß coefficients
on the right side of equation (3)).


The variables of the model (see data source in annex 1) are specified in logarithms as follows: RER is
the actual real effective exchange rate; Y is the Brazilian real GDP per capita expressed in US dollars;
ToT is the terms of trade; STKF is the net short-term capital flow expressed as a ratio of GDP;12 CA is the
current account balance expressed as a ratio of GDP; IDIFER is the differential of short-term domestic
(SELIC basic rate) and international (US Fed Funds) interest rates; IDIFERt-1 is the previous variable
lagged one period; IR is the stock of Brazilian international reserves expressed as a ratio of GDP; CR is
Brazil’s risk premium; εt is a random error variable, which is also assumed to contribute to deviating the
actual real exchange rate from its long-term trend level; and the subscript t is the time reference (in our
econometric modelling, it refers to one month).13


The variables chosen to represent the structural conditions to determine the real exchange rate are largely
used in the empirical literature (Helmers, 1988, Edwards, 1988, Rodrik, 2008). And the short-term
variables chosen are considered to be the most important for an open emerging economy according to
the specific discussion in section III.14


Following the basic econometric procedures, we investigated the potential non-stationarity of the
variables and the potential endogeneity of the chosen explanatory variables. As for non-stationarity, we
implemented the Augmented Dickey-Fuller (ADF) and the Phillips-Perron (PP) unit root tests.15 Except
for the STKF, all other variables are non-stationary in levels (with a trend and intercept), but stationary
in first differences, i.e., the series are I (1) at 5 per cent significance level. For this reason, and others
which we will further discuss ahead, we removed the STKF variable from the model. Following Baffes
et al. (1999), we consider that, since the econometric model is represented by a single equation, the most
appropriate methodologies to estimate the determinants of the real exchange rate are the ordinary least
squares (OLS) and the error correction model (ECM).


Before applying the cointegration test, it is important to stress that ECM models are generally applied to
non-stationary series which have a cointegration relationship. As supported by Campbell and Perron (1991),
in reaching a cointegrated process between non-stationary series, the addition of a stationary variable in
the ECM will not cause significant changes in the statistical robustness of the regression. However, when
we included the stationary variable STKF in our econometric implementation, the model did not show
a good fit. As we already discussed in section III, since one of the main transmission channels from the
interest rate differential to the real exchange rate is through the short-term capital flow, the removal of


12 We computed the foreign investment for portfolio and other short-term foreign investments (mainly suppliers’ credit
and short-term loans) as short-term capital flows.
13 Following Bogdanski, Tombini and Werlang (2000: 17), all variables with negative values (CA and STKF) were
transformed adding a positive number in order to apply logarithms in the following procedures: CA = 1 + CA; and STKF
= 2 + STKF.
14 These short-term variables can also be found dispersed throughout conventional empirical models. See, for instance,
Meese and Rogoff (1983), Edwards (1988), Calvo, Leiderman and Reinhart (1993), among others.
15 Results are described in annex 2.




11


this variable does not damage the consistency of the model. Therefore, by removing the variable STKF
from the econometric model, equation (3) is re-expressed by the following equation:




ttttt


tttt


CRIRIDIFERIDIFER
CAToTYcRER


εββββ
ααα


+++++
++++=


− lnln)(ln)(ln
lnlnlnln


43121


3210 (4)


Having now established that the variables of equation (4) are non-stationary and possess the same order of
integration I (1), we are able to apply the cointegration test so as to verify whether a linear combination of
these variables is stationary. Following Engle and Granger (1987), if a unit root test reveals the residuals
are stationary, i.e., I (0), we can conclude not only that all variables of our single equation are cointegrated
in levels, but also that the estimated coefficients by ordinary least square (OLS) are consistent (Hamilton,
1994: 857; Greene, 1997: 856–857). The ADF and PP tests prove we can reject the null hypothesis of
unit root in the residuals. So, according to Granger (1981) and Engle and Granger’s (1987) procedure,
since the residuals are stationary, the real exchange rate and its structural long-term and short-term
determinants are cointegrated.


To deal with the potential endogeneity issues of our explanatory variables, we followed two methodologies.
First, by applying Engle, Hendry and Richard’s (1983) weak exogeneity test, the variables GDP per
capita, international reserves and the terms of trade were revealed to be endogenous. A traditional way of
addressing the potential for the endogeneity bias is to use instrumental variables that are able to correct
the estimates through the use of exogenous variables, or instruments. Therefore, we also run the model
in two stages least squares (2SLS).


Second, as Baffes et al. (1999) argue, even the relevant exogeneity tests proposed by Engle, Hendry
and Richard (1983) might not be able to completely solve endogeneity problems when the marginal
distribution of the explanatory variables shifts. Following this argument, in a model where more than one
variable is endogenous, the Johansen (1988) cointegration procedure can be complementary for solving
the endogeneity bias, since it treats all the variables in the estimation process as endogenous and tries to
simultaneously determine the equilibrium relationship among them. Assuming that all the variables are
I(1), the Johansen procedure, which considers all the I(1) variables as if they were endogenous and related
to a vector-autoregressive structural model (VAR), uses the maximum likelihood estimation for the VAR
model and derives a set of cointegration vectors. The number of cointegration vectors is determined by
trace and eigenvalue tests (table 1).16


16 See Enders (1995) and Hamilton (1994). The null hypothesis that there is a lack of cointegration relationship is
rejected at 5 per cent significance level, both for trace and maximum eigenvalue test statistics. This means that there is
strong evidence to support the existence of a cointegration vector which represents the long-term relationship among the
variables of our model.


Table 1


JOHANSEN TEST OF COINTEGRATION RANK


Trace statistics Max-Eigen statistics


Eigenvalues
Critical
values


Prob.
5 per cent Eigenvalues


Critical
values


Prob.
5 per cent


None 177.5079 139.2753 0.0001 72.27859 49.58633 0.0001


At most 1 105.2293 107.3466 0.0683 40.66017 43.41977 0.0970


At most 2 64.5691 79.34145 0.3807 27.48926 37.16359 0.4124


Note: 4 lags, with a trend and intercept.




12


Table 2 presents the results of our estimation in OLS, 2SLS and ECM according to the econometric
model specified in equation (4).


Among the structural variables, all the three models revealed that the largest estimated coefficients were
the GDP per capita and the terms of trade, respectively.17 The real GDP per capita, with a negative sign,
supports the Harrod-Balassa-Samuelson effect. However, the high coefficient estimated for this variable
should be cautiously analysed. In fact, far from reflecting an expressive growth in either labour productivity
or even total factor productivity (TFP) in Brazil, the growth of the real GDP per capita in the last decade
(especially in the last few years) resulted from a set of well succeeded social policies which led to a
significant improvement in income distribution.18 So, rather than expressing an increase in productivity,


17 Among the structural variables, the terms of trade showed the largest estimated coefficient in the ECM model.
18 If we take into account the total factor productivity (TFP), an indicator of aggregate efficiency, the annual average
growth was less than 0.5 per cent between 2002 and 2009 (against 4 per cent in China and 2.6 per cent in India, see The
Economist, 18 November 2009).


Table 2


ESTIMATED MODEL FOR BRAZIL
DEPENDENT VARIABLE: REAL EXCHANGE RATE


Variable Description of the variables


OLS coefficient
(t-statistics
between
brackets)


2SLS coefficient
(t-statistics
between
brackets)


ECM coefficient
(t-statistics between


brackets)


C Constant 6.766*** 2.659** 4.463***
[11.610] [1.964]


lnGDP Log of the real GDP per capita -0.356*** -0.505*** -0.505***
[-6.771] [-11.588] [-9.458]


lnTOT Log of the terms of trade -0.239* 0.290* 0.568*
[-1.744] [1.732] [1.582]


lnCA Log of the current account balance/
GDP


0.129*** 0.227*** 0.230***
[8.17] [13.988] [12.636]


Ln(IDIFER) Log of the short-term interest rate
differential


0.121*** - -
[3.266] - -


Ln(IDIFER)t-1 Log of the lagged short-term
interest rate differential


-0.129*** -0.104*** -0.161***
[-3.693] [ -3.641] [-4.236]


lnIR Log of the stock of international
reserves/GDP


0.115*** 0.109** 0.139***
[4.088] [2.538] [5.511]


lnCR Log of the Brazil’s risk premium 0.065*** 0.194*** 0.072***
[2.231] [3.453] [2.815]


Note: ***Significantat1percentlevel;**Significantat5percentlevel;*Significantat10percentlevel.
Notes on OLS model:R-squared:0.88745;AdjustedR-squared:0.88169;Durbin-Watson:1.633;F-statistics:153.319;
Prob(F-statistics):0.0000;Numberofobservations:145afteradjustments.


Notes on 2SLS model:R-squared:0.8259;AdjustedR-squared:0.8178;Durbin-Watson:1.6106;F-statistics:110.661;
Prob(F-statistics):0.0000;Numberofobservations:145afteradjustments;
Instrumentlist:LOGTOT(-1);LOGIR(-1);LOGIDIFER(-2);LOGGDP(-1);LOGCR(-1);LOGCA(-1);LOGTOT(-8);LOGTOT(-9).
Notes on ECM model:4lags;Numberofobservations:141afteradjustments.




13


which has been stagnant in the 2000s, it expresses an improvement in the income distribution due to a
set of social policies (e.g., the Family Assistance Programme – Bolsa Familia, among others).


In the OLS model the terms of trade ToT presented a negative sign, so an improvement of 10 per cent in
the terms of trade appreciates the long-term trend of the real exchange rate by 2.39 per cent. However,
when this variable is considered with one or more lagged ones both in the 2SLS and ECM models,
the medium-term impact is to depreciate the Brazilian currency. So this seems to confirm the ambiguous
effects of the terms of trade on the real exchange rate, as supported by Edwards (1989) and already
discussed in section III.


The expected sign of the current account balance to GDP ratio (CA) is also ambiguous. On the one hand,
ceteris paribus, the more a country shows current account surplus, the more appreciated its currency will
be in real terms. On the other hand, we could also argue that large current account surpluses, by being
associated with large domestic savings in the long run, tend to increase the incentives of the demand
for foreign exchange for purchasing external assets and, furthermore, to depreciate the long-term real
exchange rate. Then, if this is the case, we could expect a positive sign for the current account to GDP
ratio. In fact, although the estimated sign for the Brazilian case has been positive, it is necessary to stress
that, on average, Brazil presented large net capital inflows during the period under analysis. This suggests
that Brazil’s current account balance seems to be strongly associated with a depreciated currency in real
terms, though we cannot draw any conclusion on the causality relationship between the former variable
and the Brazilian real exchange rate behaviour.


Among the short-term economic policy variables, the short-term interest rate differential and the
international reserves showed the largest estimated coefficient. Though the country-risk premium has
presented a high estimated coefficient in the 2SLS model, it presented low estimated ones in both OLS
and ECM models. Nonetheless, the estimated positive coefficient of the country-risk premium implies
that a higher coefficient of this variable is associated with an undervalued currency in real terms, as
suggested by the theoretical literature.


As supported by the analysis in section II, the very short-term impact of the interest rate differential might
reflect a “fear of inflating”, given the context of the current inflation targeting regime in Brazil. So, we
should expect a positive sign in the interest rate differential, as shown in the OLS model. At the same
time, the increase in the country’s risk premium is reinforced every time the Brazilian economy faces
either an internal or external shock, which, by indicating or eventually provoking a sudden stop in capital
flows, compels Brazil’s Central Bank to maintain the short-term interest rate differential at a high level.


On the other hand, the incorporation of the lagged short-term interest rate differential into the econometric
model is based on the assumption that the short-term interest rate differential impacts the real exchange
rate with some time lag through its effects on net short-term capital inflows, as discussed in section II. An
increase of 10 per cent in the short-term interest rate differential tends to appreciate the Brazilian currency
to a minimum of 1.0 per cent (2SLS model) and a maximum of 1.6 per cent (ECM model) in real terms.


The stock of international reserves as a ratio of GDP is, along with the interest rate differential, one of
the largest to correlate with the real exchange rate. It is necessary to stress, though, that the relationship
between this variable and the real exchange rate is ambiguous. On the one hand, by reducing the country’s
risk premium, the larger the stock of international reserves, the lower the expectation for real exchange
rate depreciation, considering everything else equal. If this is the case, the expected sign should be
negative. On the other hand, a larger stock of international reserves also reflects the central bank’s strategy
of accumulating foreign reserves as an attempt to either target a long-term “optimal” real exchange rate
(like most Asian countries) or avoid a large real exchange rate overvaluation (a defensive strategy). In
both cases, the expected sign should be positive, although the defensive strategy seems to be the case of
Brazil in the period under analysis.




14


B. The long-term trend and the long-term “optimal” real exchange rate in Brazil


Since we were able to identify two relevant groups of variables in the determination of the Brazilian real
exchange rate, our next step is to take the regressors of these variables to estimate the long-term trend of
the real exchange rate. This result is then compared with the actual real exchange rate RER to construct
an index that allows us to evaluate the trend of real exchange rate overvaluation in Brazil.


In practice, the variables of the model are likely to include both transitory and permanent components.
Thus, a strategy towards the estimation of the long-term trend of the real exchange rate can be based on
the econometric decomposition of the variables into a transitory and a permanent component. The long-
term estimated real exchange rate (RÊR) depends only on the permanent component, which reflects the
long-term trend of the series. As suggested by Edwards (1989) and Alberola (2003), this paper uses the
Hodrick-Prescott (HP) filter technique to estimate the long-term trend of the series and, furthermore, to
obtain the permanent values for the set of our long-term and short-term explanatory variables. Therefore, the
long-term estimated real exchange rate is obtained by multiplying the values of the permanent component
of both structural and short-term explanatory variables by the vector of the estimated coefficients of the
regression model.


Figure 2 jointly shows the actual (RER) and long-term estimated real exchange rates RÊR (this latter
by OLS, 2SLS and ECM models). As figure 2 reveals, the episodes that produced strong and damaging
depreciations happened exclusively in response to either internal or external shocks (such as in early 1999,
due to the speculative attack which forced the adoption of a floating exchange rate regime in Brazil; in
the first semester of 2001 in virtue of the severe electric energy crisis – the apagão crisis; in the second
semester of 2002, due to the negative expectations of the upcoming presidential elections; and in the
aftermath of the September 2008 financial crisis).


Figure 2


ACTUAL AND LONG-TERM ESTIMATED REAL EXCHANGE RATES IN BRAZIL,
FEBRUARY 1999–FEBRUARY 2011


(In logarithms)


Source: Estimatedbyauthorsaccordingtothedescribedmethodology.


Figure 2 also highlights three additional points: first, since the general trend of both actual and long-term
estimated real exchange rate is similar, the results support the robustness of our models to capture the
long-term trend of the real exchange rate in Brazil throughout the period; second, the very close results
of the estimations by OLS, 2SLS and ECM demonstrate that both the explanatory variables and the
methodologies chosen to estimate the determinants of the long-term trend of the Brazilian real exchange


4.1


4.3


4.5


4.7


4.9


5.1


5.3


RÊROLS RÊR2SLS RÊRECM RER


1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011




15


rate overvaluation are appropriate; and third, there has been a chronic tendency of the long-term real
exchange rate in Brazil to overvalue and be directed towards a “suboptimal” level. This overvaluation
trend could have only been considered “healthy” if it was explained by a significant increase in either
Brazilian labour productivity or TFP, which, as already mentioned, has not been the case throughout the
period under analysis.


Given these specificities, one could speculate what the level of the long-term “optimal” real exchange
rate should be, that is, the one that could prevent the current process of Brazilian early deindustrialization
and, hence, not damage economic development. One attempt to estimate this level could be to consider,
coherently with our previous concept of long-term “optimal” RER, a shorter period, when, roughly
speaking, the economy had shown sound macroeconomic indicators (on average) and, at the same time,
a small estimated real undervaluation. By comparing the actual real exchange rate (RER) with the long-
term estimated real exchange rate (RÊR) in the three models, we can calculate both overvaluation and
undervaluation of the RER related to the long-term estimated trend. Figure 3 shows that the actual real
exchange rate kept a small undervaluation related to its long-term estimated trend only in 1999, 2001
and between mid-2003 and mid-2005.19


Figure 3


LEVEL OF UNDERVALUATION OR OVERVALUATION OF THE ACTUAL REAL EXCHANGE RATE RELATED
TO THE LONG-TERM ESTIMATED TREND, FEBRUARY 1999–FEBRUARY 2011


Source: Estimatedbyauthorsaccordingtothedescribedmethodology.
Note: UndervaluationandovervaluationarecalculatedbythedifferencebetweentheactualRERandtheestimated long-


termtrendoftheRER(RÊR).Ifthisresultisabovezero,thereisanundervaluation;ifitislessthanzero,thereisan
overvaluation.


However, the period from mid-2003 to mid-2005 was the only one during which the Brazilian economy
combined sound macroeconomic indicators with a small estimated real exchange rate undervaluation.20
So, considering only this period, the average index of the long-term estimated real exchange rate was
129.55 (OLS: 126.47; 2SLS: 129.53; and ECM: 132.66). To illustrate, comparing this level with the
index of the real exchange rate observed in April 2011 (72.57 on average), the Brazilian real exchange


19 Note that as the actual RER related to the long-term trend was excessively undervalued from mid-2002 to early 2003
as well as in the immediate aftermath of the September 2008 financial crisis, these periods are not in accordance with the
requirement of a small undervaluation according to our concept of long-term “optimal” real exchange rate.
20 We investigated ten macroeconomic indicators, such as GDP growth, consumer inflation, international reserves/GDP,
current account balance/GDP, external debt/GDP, among others. All data from Brazil’s Central Bank.


-0.3


-0.2


-0.1


0.0


0.1


0.2


0.3


0.4


1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011


RER-RÊR2SLS RER-RÊROLS RER-RÊRECM


Undervaluation region


Overvaluation region




16


rate showed a real overvaluation of around 78 per cent related to its long-term “optimal” level (the steps
for estimating the long-term “optimal” real exchange rate are in annex 3).


By looking at the mid-2003 and mid-2005 period’s results we can assume that Brazil reached its long-term
“optimal” real exchange rate in 2004. This assumption is supported by two statistical evidences: first, in
2004 the Brazilian economy showed good performance expressed by macroeconomic indicators, such
as a real GDP growth of 5.7 per cent, a current account surplus of 1.6 per cent of GDP and an external
debt to export ratio of only 2.3 per cent, among others; and second, we realized that the estimated real
undervaluation of the Brazilian currency was around 6 per cent (on average) in 2004 (OLS: 8 per cent
2SLS: 6 per cent; and ECM: 4 per cent).21 This level is consistent with the empirical literature’s conclusion
according to which a small real undervaluation is the best policy for assuring economic development
(Rodrik, 2008; Williamson, 2008). By following the same procedures as described above, in April 2011
the Brazilian actual real exchange rate showed a real overvaluation of around 80 per cent in relation to
its long-term “optimal” level.22 To give an idea of this, in April 2011, the average nominal exchange rate
should have been around 2.90 Brazilian reais per dollar (against an observed nominal rate of 1.59 Brazilian
reais per dollar) to achieve the 2004 “optimal” level (average of the year).


V. CONCLUDING REMARKS AND ECONOMIC POLICY IMPLICATIONS


In the recent experience of a floating exchange rate regime with relatively high capital movements in Brazil,
policy-makers clearly face the challenges imposed by the trilemma of economic policy. So, finding out
how to overcome the “impossible trinity”, that is to say, how to choose two out of three competing policy
goals – monetary independence, exchange rate stability and high external financial integration – should
still be on the agenda of the Brazilian economic policy. In practical terms, it is not an exaggeration to say
that Brazilian policy-makers, by having pursued monetary independence to assure price stability and high
external financial integration as priority goals for economic policy in the last decade, have tolerated the
high volatility and a large overvaluation trend of the real exchange rate. This trend is supported by our
econometric equation that allowed us to estimate the real exchange rate throughout the 2000s, combining
structural long-term variables and short-term economic policy variables.


Aizenman et al. (2010) showed econometric evidence that, since the 1997 financial crisis, Asian emerging
market economies have been successful in dampening the negative impacts of large short-term net capital
flows on the real exchange rate overvaluation through massive accumulation of international reserves. The
authors suggest that “policy makers in a more open economy would prefer to pursue greater exchange
rate stability” (p. ii). Nevertheless, in the case of Brazil, since our econometric results reveal that the
actual real exchange rate was significantly overvalued in April 2011 (around 80 per cent) in relation to its
long-term “optimal” level, it is not recommended to introduce policy instruments too quickly to correct
this high level of overvaluation. Needless to say, taking into account that the terms of trade will likely be
favourable to Brazil in the next few years, if the high interest rate differential in Brazil is not reduced, it
is likely that the trend of overvaluation will continue. Actually, in such a context, the high interest rate
differential reinforces the tendency to overvalue the Brazilian currency. Since Brazilian policy makers
are facing difficulty in their economic policy choices, the most appropriate macroeconomic policy is to
implement a mix of policy instruments which should prevent the strong trend of overvaluation while


21 By looking at figure 1, one could question the choice of the year 2004 – see the controversy that followed the publication
of our results released in the two articles in the Brazilian newspaper Valor Econômico (2011), arguing that the Brazilian
actual real exchange rate was excessively undervalued. And, in fact, it was. However, since this conclusion is based only
on the actual RER, for empirical purposes, the correct index for estimating either the undervaluation or overvaluation
is that one which compares the actual RER with the long-term estimated RER. So, the correct procedure is to look at
figure 3, instead of figure 1.
22 This should be taken as a preliminary exercise, as the explained variable, the actual real effective exchange rate, is
based on a basket of currencies and not on the United States dollar.




17


preserving price stability. This challenge demands policy makers to assume a target for the “optimal”
level of the real exchange rate in the medium and the long-run. This goal is more or less in line with the
UNCTAD’s recent proposal of using the “real effective exchange rate (REER) as a simple and viable
system for averting exchange rate misalignment and the prevention of carry trade based on currencies”
(UNCTAD, 2011: 1).23


First of all, the policy space for avoiding the real exchange overvaluation through accumulation of
international reserves is much more limited in Brazil than in Asian emerging market economies, because,
by virtue of maintaining high Brazilian interest rates, this strategy has adverse effects on the gross public
debt. However, our econometric exercise showed that the estimated coefficient of the stock of international
reserves had a positive sign and was statistically significant. This means that, even taking into account
that this strategy can increase the gross public debt, this economic policy mechanism has been somewhat
influential in mitigating the real exchange rate’s trend of overvaluation and has contributed to offsetting
high volatility. So, as long as policy-makers are able to manage the impact of interventions on the spot
and forward foreign exchange markets on the growth of gross public debt, Brazilian monetary authorities
should continue to pursue the strategy of accumulating international reserves.


Secondly, the terms of trade figured in the OLS model as one of the main structural factors responsible for
the overvaluation trend of the Brazilian currency in the long run. Since this result is explained in turn by
the recent behaviour of the high relative prices of agricultural products and manufactured commodities
in global markets, the basic policy implication is that Brazilian authorities should neutralize the threat
of the so-called Dutch disease by implementing industrial and technological policies with the goal of
reallocating resources and promoting structural change towards sectors that are technologically more
sophisticated. In this sense, a strong ally of industrial and technological policies is the commitment to
keep the real exchange rate slightly undervalued in real terms in the long run, say around 5 per cent.


Thirdly, since the short-term interest rate differential in Brazil has figured as one of the highest in the
capitalist world, Brazilian monetary authorities should enlarge the policy space for bringing the domestic
interest rates to levels closer to international standards, and so contributing to the undervaluation of the
domestic currency. One could argue that this possibility is very limited in Brazil, as the main concern
of the inflation target regime is price stability. However, this goal is not incompatible with the effort to
reduce domestic interest rates. There are academic studies suggesting that the design of the inflation target
regime in Brazil could be modified in order to give monetary authorities more room to reduce the SELIC
basic interest rate. One of the recommendations is to manage the inflation target through a calendar year
of 18 months (see, among others, Oreiro et al., 2009; and Squeff et al., 2009).


Fourthly, we also agree that fiscal policy responsibility, through which the growth of current government
expenditures in real terms is lower than the increase of the real GDP, could contribute not only to supporting
a drop in Brazilian policy interest rates (the highest in capitalist world in current days – August, 2011),
but also to augmenting the public investment to GDP ratio in Brazil.24 It is necessary to remark, however,
that, without some change in the conservative way with which the Brazilian inflation targeting regime
has been managed since it was introduced in 1999, fiscal policy responsibility per se is not sufficient
for reducing high interest rates in Brazil. It is important to recognize that there have been small changes
in the way Brazil’s Central Bank manipulates the monetary policy under the inflation target regime.
After September 2008, Brazil’s Central Bank has been adding other instruments and strategies, besides


23 According to the UNCTAD’s proposal, the most appropriate observed indicator for estimating the misalignment of
the REER is the unit labour cost (that is, the premium of nominal wages over total productivity of the economy) rather
than consumer price indices. So, policy-makers should target the “equilibrium” real exchange rate by realigning nominal
exchange rates to the domestic cost level. For details, see UNCTAD, 2011.
24 The total investment of the central government as a proportion of Brazilian GDP was only 1.3 per cent in 2010, a very
low rate for a country with poor physical and social infrastructure.




18


the management of the SELIC rate, such as compulsory reserve requirements, capital requirements to
strengthen bank balance sheets and the apparent and undeclared acknowledgement of the challenges and
high costs associated with reaching the current inflation target (4.5 per cent for 2011) in a single calendar
year. The doubt is whether or not these changes will be maintained.


Finally, Brazilian policy-makers should not discard the use of more effective mechanisms for capital
control as suitable mechanisms for economic policy. Taking into account that international interest rates
might be maintained at a very low level in the near future, due to the stagnant environment in the world
economy, the high short-term interest rate differential will continue to contribute to the appreciation of
the Brazilian currency in real terms. Even conservative voices have upheld that some sort of protection
against speculative short-term capital inflows should be established by emerging economies to avoid
exchange rate overvaluation. A recent International Monetary Fund Staff Position Note (see Ostry et
al., 2010, among others) concluded that “capital controls are a legitimate part of the toolkit to manage
capital inflows in certain circumstances” (p.15).25 In fact, when a first draft of this paper was concluded
in May 2010, almost no capital control measures had been adopted by the Brazilian authorities, although
the overvaluation trend of the Brazilian currency had been continuing since 2004. As this trend deepened
in 2010, a set of measures of capital control – until then a forbidden topic among Brazilian economic
policy-makers – have been introduced up to July 2011, most of them involving financial tax on short-
term capital inflows directed to bond purchases and transactions tax on future markets (especially on the
currency derivatives market).


The main issue is that these governmental measures (including the mix of the above suggested
macroeconomic policies) should have been implemented in mid-2009, when the real exchange rate
began to show a sustained trend of appreciation again – once having overcome the strong depreciation
that follow the September 2008 financial crisis – and not in ad hoc small doses as has ocurred from early
2010 on. Currently (August 2011), as the current account deficits have increased dramatically from 2009
to 2011, the imposition of radical measures of capital control (e.g. quantitative constraints against capital
inflows) is much harder to implement, given the need of large amounts of external savings to finance the
current account deficits. In other words, it is much more difficult to find an organized exit from a potential
exchange rate crisis when the country’s external financial vulnerability has dramatically increased.26


To conclude, there are at least two reasons the strong real exchange overvaluation should have been
avoided: first, as has been strongly supported by the empirical literature, a large and continued overvaluation
in the short-term can damage long-term economic growth; and second, as stressed by Dornbusch (1988) a
long time ago, although a floating exchange regime can provide for the correction of overvaluation in the
medium term, the aftermath of a correction by free-market forces is far from being a “first best” solution
since it can lead to severe macroeconomic instability and requires high adjustment costs: balance-of-
payments crises, inflation, high interest rates and real GDP reduction.


25 For a detailed country study on short and medium run capital control experiences, see BIS, 2008.
26 Between 2009 to June 2011 (yearly basis), the current account deficits have increased from US$24 billion (1.5 per cent
of GDP) to US$49 billion (2.2 per cent of GDP). Although Brazil’s Central Bank statistics account for large amounts of
foreign direct investment, most of these have been related to intrafirm lendings.




19


Annex 1


DESCRIPTION OF THE DATA SOURCE


Actual real effective exchange rate – estimated by Brazil’s Central Bank (http://www.bcb.gov.br).


Brazilian GDP per capita expressed in US dollars – estimated by Brazil’s Central Bank based on statistics
on monthly real GDP in R$ Brazilian Real (series No. 4383) and transformed into United States Dollar
according to IPEAdata series of exchange rates. Population estimated by the Brazilian Institute of
Geography and Statistics (IBGE) (http://www.bcb.gov.br).


Terms of trade – estimated by FUNCEX- FUNCEX12_TTR12 (http://www.funcex.com.br).


Current Account Balance – Balance of Payments, Brazil’s Central Bank (http://www.bcb.gov.br).


GDP in current United States dollar – Brazil’s Central Bank (series no. 4; http://www.bcb.gov.br).


Short-term interest rate differential – difference between Brazil’s Central Bank monthly interest rate
series for SELIC (BCB Boletim/M.Finan. – BM_T JOVER12 – http://www.bcb.gov.br) and the US FED
FUNDS monthly interest rate (IFS/IMF – IFS12_TJFFEUA12).


Net short-term capital flow – Balance of Payments, Brazil’s Central Bank (http://www.bcb.gov.br).


Stock of international reserves – Brazil’s Central Bank (series no. 3546; http://www.bcb.gov.br).


Brazil’s risk premium (EMBI Brazil sovereign foreign currency) – Standard&Poors monthly series.


Table A.1


UNITY ROOT TESTS IN THE RESIDUALS


Critical values: 1 per cent


Tests t-statistics 1 per cent 5 per cent 10 per cent


ADF -4.524946 -2.58195 -1.943175 -1.615168


PP -7.393642 -2.58112 -1.943058 -1.615241


Note: TheADFandPPtestswereappliedtoresidualswithouteithertheconstantortrend.


Annex 2




20


Table A.2


AUGMENTED DICKEY-FULLER TEST (ADF): IN LEVELS AND FIRST DIFFERENCES


Critical values


Variable lags t-statistics 1 per cent 5 per cent 10 per cent


RER 1 -1.756 -4.024 -3.442 -3.146
GDP 2 -2.511 -4.024 -3.442 -3.146
TOT 1 -1.006 -4.024 -3.442 -3.146
CA 5 -1.2267 -4.024 -3.442 -3.146
IDIFER 3 -2.897 -4.024 -3.442 -3.146
STKF 0 -11.733 -4.024 -3.442 -3.146
IR 0 -2.545 -4.024 -3.442 -3.146
CR 3 -2.243 -4.024 -3.442 -3.146


Critical values


lags t-statistics 1 per cent 5 per cent 10 per cent


RER 0 -9.999 -4.024 -3.442 -3.146
GDP 1 -9.857 -4.024 -3.442 -3.146
TOT 0 -15.695 -4.024 -3.442 -3.146
CA 4 -11.327 -4.024 -3.442 -3.146
IDIFER 2 -5.804 -4.024 -3.442 -3.146
STKF 3 -10.675 -4.024 -3.442 -3.146
IR 0 -12.859 -4.024 -3.442 -3.146
CR 0 -11.605 -4.024 -3.442 -3.146


Note: Withatrendandintercept,exceptSTKFwithonlyanintercept.


Annex 2 (concluded)


Table A.3


PHILLIPS-PERRON TEST (PP): IN LEVELS AND FIRST DIFFERENCES


Critical values


Variable lags t-statistics 1 per cent 5 per cent 10 per cent


RER 4 -2.33 -4.022 -3.443 -3.145
GDP 8 -2.238 -4.022 -3.443 -3.145
TOT 5 -2.109 -4.022 -3.443 -3.145
CA 8 -2.779 -4.022 -3.443 -3.145
IDIFER 0 -3.016 -4.022 -3.443 -3.145
STKF 4 -12.097 -4.022 -3.443 -3.145
IR 0 -2.545 -4.022 -3.443 -3.145
CR 2 -2.376 -4.022 -3.443 -3.145


Critical values


lags t-statistics 1 per cent 5 per cent 10 per cent


RER 0 -9.714 -4.022 -3.443 -3.145
GDP 2 -10.066 -4.022 -3.443 -3.145
TOT 0 -15.695 -4.022 -3.443 -3.145
CA 18 -49.772 -4.022 -3.443 -3.145
IDIFER 5 -19.074 -4.022 -3.443 -3.145
STKF 28 -55.767 -4.022 -3.443 -3.145
IR 3 -12.876 -4.022 -3.443 -3.145
CR 0 -11.615 -4.022 -3.443 -3.145


Note: Withatrendandintercept,exceptSTKFwithonlyanintercept.




21


Annex 3


STEPS FOR THE ESTIMATION OF THE LONG-TERM
“OPTIMAL” REAL EXCHANGE RATE


1. In the first step, we chose a shorter period during which the Brazilian economy showed good
macroeconomic indicators, such as real GDP growth, current-account surplus to GDP, external debt
to export ratio, among others. According to data from Brazil’s Central Bank and the International
Monetary Fund, this shorter period occurred from July 2003 to June 2005.


2. In the second step, we obtained the long-term “optimal” real exchange rate by multiplying the
vector of the estimated coefficients of the regression model by the permanent components of the
explanatory variables from July 2003 to June 2005.


3. Finally, after calculating an arithmetic average of the previous values, as all series are in logarithmic
terms, we used the anti-logarithmic function to find the index of the real exchange rate.




22


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25


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