How to cure the trade balance? Reducing budget deficits versus devaluations in the presence of J- and W-curves for Brazil

Abstract

We analyze empirically for Brazil a hypothesis by Stiglitz (2002) saying that devaluations may be more effective in reducing trade deficits than cuts in budget deficits. We find that the Ricardian equivalence does not hold. Devaluations have a stronger impact on the trade deficit than budget deficits when doing the analysis with yearly or monthly data even when the effect from a risk variable obtained from a TARCH estimate is subtracted. Devaluations have an effect that lasts 25 months. A J-or W-curve can be obtained from a polynomial distributed lag estimate. Devaluations can explain almost 19% of consumer price inflation. However, if inflation control is a task assigned to monetary policy rather than exchange rate policy, devaluations are available as an instrument to stabilize the trade balance under shocks rather than keeping exchange rates fixed through sales of reserves. This may avoid overvaluations, speculative attacks and currency crises. The results for the trade balance hold for several updates except for the last one, where budget deficits and exchange rate changes change signs. This suggests a role for imported investments and elasticity pessimism and casts doubts on the role of cutting budget deficits and devaluations in regard to the trade balance. Stability tests suggest that structural change seems to play a role. The change in signs of our estimates may have been caused by a change of exchange rate policies leading to appreciations since June 2004 and by an extraordinarily strong industrial recession in 2003 in some countries. If Ricardian equivalence for the trade balance is imposed by assumption we find a weakly significant N-curve for exchange rate risk jointly with a J-curve for devaluations.