Fiscal vulnerability in Brazil: a simulated method of moments approach

Abstract

This article estimates a structural macroeconomic model of the Brazilian economy, with emphasis on the exchange rate, interest rate, inflation and public debt risk premium. The aim is to assess the effect of different fiscal trajectories on the solvency of the public debt and possible episodes of fiscal vulnerability (defined here as a situation where the government’s fiscal precariousness prevents the central bank, in certain contexts, from reducing inflation by raising the basic interest rate). The change in relation to the usual case is the inclusion of a measure of the endogenous variation of the debt risk premium. To get around the usual problem of endogeneity in estimating a system of structural equations, we use the simulated method of moments (McFadden, 1989). Besides being more flexible than the techniques usually applied in the literature, this method enables stochastic projections under different macroeconomic settings to be obtained. We use alternative fiscal scenarios, associating each one with different likelihoods of fiscal vulnerability generated by the resulting distinct evolutions of the debt/GDP ratio.