South-Western College Publishing - Economics  

Real Uncertainty in Brazil
Subject Devaluation
Topic International Finance
Key Words Devaluation, Brazil, Financial Markets
News Story Add Brazil to the list of countries affected by the recent turmoil in financial markets. Brazil's stock market has declined by 30% and there is speculation that Brazil may be the next target for foreign currency speculators. These fears have put pressure on Brazil to devalue its currency in an effort to restore confidence in the real, Brazilís currency. The monetary authorities in Brazil nearly doubled its benchmark interest rate last week in an effort to strengthen the real. The government also spent between $7 and $10 billion to prop up Brazilís currency. There are estimates that the government of Brazil has as much as $30 billion in reserves that could be used to defend the real and President Fernando Henrique Cardoso has assured investors that Brazil will do so. The real is about equal to the dollar but many believe that it is overvalued, perhaps by as much as 30%. The prospect of devaluation leading to higher inflation and increased uncertainty in Brazilís financial markets has caused a drop in consumer confidence. The higher interest rates and lowered confidence has resulted in consumers postponing or avoiding purchases. Many stores this past weekend had more clerks than customers.

Brazilís recent problems may reverse what has been four years of economic progress. In 1994, Brazil introduced the real and a string of economic reforms including tying the real to other major currencies. Brazil lifted trade barriers and began to sell off unprofitable state-owned enterprises. The result was a marked decrease in inflation Ė from 50% a month to less than 10% per year, financial stability, and increased foreign investment. (Updated January 15, 1998)

Questions
  1. Draw a demand and supply diagram illustrating the foreign exchange market for dollars in Brazil. Make sure that your axes are labeled correctly. Indicate the equilibrium exchange rate and volume of foreign exchange.
  2. Assuming the exchange rate between dollars and reals is permitted to vary only slightly from the rate established in 1., suppose there is an increase in the demand for dollars, what will happen to the exchange rate?
  3. What factors might cause an increase in demand for dollars?
Source Calvin Sims, "Worry Over Brazilís Money Chills the Shopping," The New York Times, November 3, 1997

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