South-Western College Publishing - Economics  
Real Troubles for Brazil
Subject Economic Growth
Topic International Finance
Key Words Economic Growth, Expansion, Poverty, Inflation, Income Distribution
News Story

Brazil's economy, the largest in Latin America and the ninth largest in the world, is in trouble. The economy is being felled by growing current account deficits, fiscal deficits, and a growing fear that the financial crisis that has devastated parts of Asia and Russia was headed south to Brazil. Since Brazil opened its markets to foreign investors, billions of American dollars have flowed into its economy. An economic collapse in Brazil would have severe consequences for the U.S. economy.

Less than a decade ago, Brazil's economy was plagued by rampant inflation, low growth and high unemployment. Fernando Cardoso, then Finance Minister, introduced an economic reform package called the Real Plan which called for a new currency, the real, the privatization of state industries, the removal of exchange controls, and reform of social security, tax and Civil Service systems. The plan was very successful; inflation was brought down to negligible levels, real incomes grew and unemployment fell. Last year, foreigners invested $17 billion in Brazil, making Brazil the world's third largest market for direct foreign investment. Cardoso rode his successful plan to become President of Brazil.

The economic turmoil that has been sweeping Asia, has come to Brazil. Nearly $1 billion a day in foreign reserves has been leaving the country. Brazil's stock market has been on a roller coaster ride - down 15 percent one day, up 17 percent the next. Interest rates are rising rapidly. Unemployment in Saġ Paulo is 19 percent and is expected to worsen. Brazil's budget deficit, currently at 7 percent of gross domestic product, and Brazil's current account deficit at $35 billion, are likely to swell, partly as a result of the steep rise in interest rates. President Cardoso has been criticized for not putting all of the reforms in place. Tax reform, the social security overhaul and Civil Service reform were either delayed, botched, or simply not carried out.

Cardoso has blamed Brazil's troubles on outside forces and has called for reforms of the international monetary system. He has not asked the International Monetary Fund for help yet, and has ruled out devaluation as a feasible policy. Brazil will most likely be forced to reduce the budget deficit through reductions in spending and/or tax increases, as well as imposing import restrictions. Cardoso is up for reelection and voters appear to have confidence in his ability to repair Brazil's economy. (Updated October 15, 1998)
Questions

1. Draw a demand and supply curve for dollars in Brazil. The vertical axis represents the exchange rate of dollars for reals and the horizontal axis the amount of dollars in Brazil. What happens to the exchange rate if there is a strong increase in the demand for dollars?

2. In the above diagram, what happens to the excahnge rate if there is a sharp decrease in the supply of dollars?

3. Given the economic situation in Brazil, what factors might explain the increase in demand for dollars and the decrease in supply of dollars?

4. Suppose that Brazil tries to fix the exchange rate of dollars to real. What will happen to Brazil's supply of foreign reserves? Why?
Source Diana Jean Schemo, "Brazilians Fret as Economic Threat Moves Closer," The New York Times, September 20, 1998

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