The inflationary consequences of fiscal policy in Brazil: An empirical investigation with regime switches and time-varying probabilities

Before the Real plan was launched, five major stabilization plans failed to control Brazil's chronic inflationary process. A loose-stance fiscal policy, associated with widespread price indexation and a passive-stance monetary policy, was thought to drive the ever-growing rate of prices as well as the acceleration of inflation. This direct connection between fiscal imbalances and inflation appeared to cease, however, in the post-Real period. The end of the inflation tax and the lack of new fiscal measures to restore fiscal sustainability caused the government's fiscal imbalance to deteriorate even further after 1994, but intriguingly enough, inflation remained at bay. Trying to shed some light on this matter, I estimate a set of regime-switching models with time-varying transition probability matrices, using Brazilian inflation data from the sample period comprising the six major plans (1981 through 1998). My objective is to investigate the existence of a nonlinear connection between fiscal and monetary policy variables and inflation. The empirical findings presented here indicate that after 1994, the connection between inflation and fiscal/monetary policy is best explained along the lines of Drazen and Helpman's (1990) and Sargent and Wallace's (1981) "unpleasant monetarist arithmetic." A faster growth rate of real debt to GDP is unambiguously bad news for inflation stabilization because it increases both the chances of remaining in the high-inflation state as well as that of switching from the low- to the high-inflation regime. Following the same argument, high real interest rates have a perverse and unorthodox effect on inflation expectations by boosting the likelihood of a switch away from the low-inflation regime.