Effect of exchange rates in Brazil based on monetary policy

International Economics

Country X has a flexible exchange rate system and open capital flows. Last year GDP decreased 8% due to the Covid-19 pandemic. Growth was better than expected thanks to the fiscal stimulus implemented by the government last March. It was among the largest for G20 countries and raised the primary fiscal deficit to 12 percent of GDP.

The government’s next steps will be decisive for the direction of the country this year. Pundits claim that a tough fiscal restraint is needed. Country X has to pay more than USD 150 billion of public debt only in the first semester of 2021. Thus, a fiscal adjustment is essential.

Assume that political hurdles impede the necessary fiscal adjustment in 2021. In this case, what would you expect to happen with the following variables in X. Explain clearly:

(i) The exchange rate of the real vs. the US dollar
(ii) Current account balance.
(iii) Inflation rate.
(iv) Foreign debt over GDP.

Sample Solution