Asset Substitution, Money Demand, and the Inflation Process in Brazil

By Calomiris, Charles W.; Domowitz, Ian | Journal of Money, Credit & Banking, February 1989 | Go to article overview
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Asset Substitution, Money Demand, and the Inflation Process in Brazil


Calomiris, Charles W., Domowitz, Ian, Journal of Money, Credit & Banking


Asset Substitution, Money Demand, and the Inflation Process in Brazil

THE RELATIVE SOPHISTICATION OF FINANCIAL MARKETS in Brazil sets it apart from other developing economies. In the last twenty years, Brazil has proved fertile ground for financial innovations in response to high rates of inflation, reserve requirements, and low or zero nominal interest rate ceilings on conventional bank accounts. These innovations include the rapid growth of relatively unregulated finance companies, the emergence of a fledgling equities market, reductions in bank transacting costs through computerization, and the use of bank repurchase agreements as substitutes for conventional deposits (Gelb et al. 1980).

Primary and secondary markets for government securities, which also provide the basis for bank repurchase agreements, emerged in the early 1970s as well. These securities provided a convenient source of funds for the government in the face of shrinking money demand as they permitted agents to maintain relatively high yields and liquidity without resort to nonfinancial or foreign assets. Though the availability of treasury bills and indexed bonds contributed to the falling demand for money, the minimum denomination and transaction costs associated with holding and trading these instruments ensured that some agents would retain funds in zero or low-interest accounts. At the same time, those who might have transferred funds out of the domestic financial system, and beyond the reach of the government, were offered relatively attractive alternatives. Thus one can view the creation of these securities as a discriminatory financial taxation policy in which the most inelastic asset demands receive the highest taxation rates.

The peculiar features of Brazil's financial system have been recognized as a stumbling block to estimating the demand for money and for isolating the role of money in the inflation process (Gelb et al. 1980). Below we present evidence that the availability of alternative assets as a source of finance for the government and a store of value for agents has had important quantifiable effects on the demand for money and the relationships among government deficits, money growth, and inflation. Taking account of alternative assets allows one to explain much of the observed rise in monetary velocity (see Figure 1) and the puzzling fact that Brazil, unlike other high-deficit developing economies experiencing high inflation, shows money growth innovations following rather than preceding those in inflation (Hanson 1980).

We first develop a steady-state model of money-market equilibrium, which stresses the long-term connections between government financial policy, inflation, and real asset supplies and demands. This equilibrium model is nested within a short-term dynamic model allowing deviations from equilibrium in section 2. In estimating and testing the model we pay particular attention to problems of model specification commonly encountered in the estimation of money demand equations. We find that--contrary to the results of previous studies--Brazilian money demand appears responsive and stable. Section 3 turns to the issue of the connection between government deficits and inflation. There we argue that the peculiar pattern of intertemporal "cause and effect" between money and prices in Brazil is consistent with the predictions of section 1. Specifically, innovations in deficits can be seen as the "forcing process" to which other nominal variables respond.

1. ESTIMATING MONEY DEMAND

The estimation of money demand provides a short-term indicator of economic activity and a long-term guide to inflation targeting. In Brazil, selective government intervention in asset markets (e.g., interest rate ceilings, time-varying inflation indexation rules and treasury bill supply policy) along with high and changing rates of inflation make interest rates unappealing short-term indicators. Data on GNP is generally considered poor and is subject to extensive revisions.

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