brazil

Brazil’s monetary policy transmission mechanism is the channels through which changes in the policy rate - the Selic rate - Brazilian federal funds rate.

Changes in Selic, in turn, affect the behavior of the economic variables, mainly prices and output through the following channels:

1. consumption and investment decisions
2. credit channel
3. exchange rate
4. expectations

Now, let’s consider in detail the peculiarities of each of these transmission channels.

Saving and investment

The transmission channel of interest rates to consumption and investment decisions is the most known monetary policy transmission mechanism, When the Copom raises the target for the Selic rate rises, real interest rates also tend to increase, which in turn tend to lead to a decrease in investment and consumption of firms and households, reducing the demand for goods and services in the economy, thus contributing to the reduction of inflation. However, in Brazil the transmission mechanisms work much faster, compared to the US and Ukraine, usually, it takes up to 12 months, compare to 18-24 in the US. This result is consistent with the structural features of the Brazilian economy (shorter maturity of domestic credit and relatively high exchange rate pass-through).

Brazil has the highest one in a world real interest rate, which is the lending interest rate adjusted for inflation as measured by the GDP deflator) of 23.15% as of 2021. Note that this is not a Selic rate - inflation.

There is a lot of reasons for such a high lending interest rate, one of which is public lending at subsidized rates. While this type of lending was one of the most effective countercyclical tools the Brazilian authorities used during the post-Lehman crisis, its use in normal times should be mindful of the fact that it may also be reducing the transmission mechanism of monetary policy and contributing to a higher market-determined equilibrium interest rate. (This is an interesting case for Ukraine, which recently introduced a subsidized 5-7-9 lending program).

Interesting, that such a situation with a very high real interest rate together with fiscal reforms helps decrease the shadow economy from 45% to 32% over the last decade and reduce extreme inequality by increasing Gross domestic savings.

The bank credit channel

The bank credit channel is found to be a more important role, than in other IT adopters, in monetary transmission because in Brazil there is an intra-temporal effect caused by changes in lending-deposit spread - monetary tightening tends to appreciate the exchange rate in the short run and this has an expansionary effect on bank credit.

This occurs because the domestic business sector tends to have a sizeable stock of foreign-currency-denominated debt and the non-tradable sector of the economy is more “bank-dependent” than its tradable counterpart, implying that the overall demand for bank credit will tend to increase as relative prices shift towards non-tradable producers. This combination of the balance-sheet effect of currency mismatches and the greater bank dependence of domestic firms - which have been shown to be typical of emerging markets - imply that monetary policy will have non-trivial effects on bank lending and hence on absorption. Academic studies indicate that, while the inter-temporal channel eventually wins out, so that monetary tightening depresses bank credit, the intra-temporal channel appears to play an offsetting role.

Exchange rate

The exchange rate is found to be important even though is a relatively closed economy to foreign trade, compared to Ukraine with a twice higher import as a portion of GDP ratio than in Brazil. Only 16% vs 40%.

In particular, the exchange rate response to domestic policy interest rate changes is sizeable and akin to results from structural models that are based on uncovered interest parity.

Also, some studies find that the large appreciation of the real since 2006 has contributed significantly to the fall in inflation. In a similar vein, academics find that exchange rate movements affect inflation expectations, and, through this channel. the central bank interest rate setting. This suggests that the exchange rate may not only affect current inflation by changing the cost of imported goods but as well, there may be an important expectational channel at work.

Conclusions: 

Brazil is the most closed economy in the world with the highest one in the world real interest rate of 23.1%.

Brazil’s monetary policy has successfully reduced shadow economy size from 45% to %32 over the last decade.

However, despite that inflation target being achieved, BCB has lost control over economic growth - GDP falling and unemployment growth since 2015.

Lesson for Ukraine - by using monetary instruments it’s possible to significantly reduce shadow economy size.