South-Western College Publishing - Economics  
Real Trouble
Subject Currency Union
Topic International Finance
Key Words Currency union, monetary policy, unemployment
News Story

Brazil's currency, the real, was devalued in January of this year. The central bank allowed the real to float in the foreign-exchange market. As a consequence, the real initially lost about 40 percent of its value, plunging to more than 2.00 reals to the dollar. The real started to gain in value but has recently come under pressure, falling for the first time since March, to the 2.00 reals per dollar level. Forecasts are for pressure on the real to ease.

The real has been falling in value in recent months due in part to dollar buying by the government to meet its foreign debt obligations and data showing that wholesale prices have risen. Longer-term prospects for the real are positive, since the government has paid the bulk of its foreign-debt obligations for October; November's payments are only $320 million. Brazil has refinanced its Brady bonds, and its hard-currency reserves will increase as a result. Government balance sheets continue to show signs of improvement.

Exchange rate fluctuations do not seem to be a major concern of Brazil's central bank. Wholesale prices, although on the rise, have not translated into retail price increases. The central bank manages interest rates based upon inflation targets and not exchange rates. A weaker real will result in increased inflationary pressure as import prices increase, but the central bank believes that inflation will still fall within its target of 8 percent.

(Updated December 1, 1999)

Questions
1. Prior to January of this year, Brazil attempted to fix the real's exchange rate. Show, using a demand and supply diagram, how a central bank could establish a fixed exchange rate between the real and the dollar.
2. After January, Brazil allowed the real to float. How is the value of the real determined in a foreign exchange market where the real floats?
3. What happens to the real when:
a. U.S. interest rates increase
b. U.S. inflation increases
c. Brazil's inflation increases.
Source Peter Fritsch, "Brazil's Currency Feels the Pressure But Is Expected to Hold Against Dollar," The Wall Street Journal, October 22, 1999.

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