The Dynamics of Chronic Inflation in Brazil, 1968-1985

Author(s): Dick Durevall

Source: Journal of Business & Economic Statistics, Vol. 16, No. 4, (Oct., 1998), pp. 423-432
Published by: American Statistical Association
Stable URL: http://www.jstor.org/stable/1392611
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The

Dynamics

of

Chronic

Inflation

in

Brazil,

1968-1985
Dick DUREVALL
Departmentof Economics,School of Economics and CommercialLaw,G6teborgUniversity,
Box 640, SE-40 530 Gothenburg,Sweden (econddur@redcap.econ.gu.se)
This articledevelopsan error-correction
model with the aim of analyzingthe behaviorof prices
duringa periodof chronicinflationin Brazil.The degreeof inflationaryinertiais estimated,and
in thedomestic-money,
testsfor the importanceof disequilibria
foreign-goods,labor,anddomesticgoods marketson inflationarecarriedout.
KEY WORDS: Cointegration;
Error-correction
model;Inertialinflation.

The purposeof this articleis to analyzethe inflationary

process in Brazil over 1968-1985. Duringthis period,the
yearly rate of inflationvariedfrom somewhatbelow 20%
in the years priorto the first oil shock to almost 250% at
the end of 1985. High and persistentinflationof this kind
is labeledchronicinflation(Beckerman1992, p. 1).
I start by specifying long-runequilibriain the monetary and foreign sectors, from which inflationis usually
assumedto originatein an open economy.Then I develop
an error-correction
model (ECM)to analyzethe dynamics
and long-rundeterminantsof chronicinflation.In estimating the model, I first test for cointegrationin the money
and foreign-exchangemarketsusing the Johansenprocedure. The cointegrationvectors are included in an autoregressivedistributed-lagmodel, which is tested to make
*surethat the assumptionsregardingits stochasticproperties are fulfilled.Next, this overparameterized
model is reduced to obtain a parsimoniousrepresentation.I then test
for (andfindinsignificant)omittedvariablessuch as wages,
the outputgap,alternativemeasuresof money,andso forth.
Finally,the stabilityof the model is investigatedusing recursiveestimation.Domestic inflationappearsto be determined by foreign prices and the exchangerate in the long
run,with dynamiceffects from money,output,the interest
rate, and oil prices.
The periodcoveredby the studyis basedon my interest
in chronicinflationandis moreor less the samesamplethat
has been used in severalotherstudies(see BarbosaandMcNelis 1990;Parkin1991;Novaes 1993).The analysisbegins
in 1968 becauseindexation,which is one of the maincharacteristicsof chronicinflation,becamewidespreadin Brazil
in the mid-1960s.Indexationincludedwages,rents,government bonds, taxes, deposit rates, and so forth. Moreover,
beginningin 1968, a policy of gradualforeign-exchange
adjustmentwas adopted,which impliedthat the exchange
rate becameindexedas well.
The study ends in 1985 because the second half of the
1980s and the beginningof the 1990s are betterdescribed
as a periodof mega-inflationor hyperinflationratherthan
chronicinflation.Therewas a sharpdecreasein pricestability, and yearly inflationratesreachedfour-digitlevels (see
Cardoso1991). The changebegan with the CruzadoPlan,
launchedin February1986. The plan consisted of price,

wage,andexchange-ratefreezesanda virtualeliminationof
indexation.After the plan collapsedin late 1986, inflationand-stabilization
cycles occurredtime andagain,with price
freezes, relaxationof price controls, and expectationsof
new price freezes (Kiguel and Liviatan1991). From 1992
to June 1994, inflationrose from about20% per monthto
40% per month, and then it was stoppedabruptlyby the
Real Plan,launchedin July 1994.
Section 1 providestheoreticalandhistoricalbackground.
In Section2 I brieflyreviewthe dataanduse the Johansen
procedureto test for (and find) the cointegratingvectors.
The ECMof inflationis estimatedand analyzedin Section
3, and Section4 concludes.
1. ECONOMIC
THEORYAND
BACKGROUND
HISTORICAL
I shall,in this section,firstoutlinethe theoreticalmodels
used in accountingfor the long-runrelationsin my data.
Then I presentthe ECM and discuss how it is relatedto
othermodels thathave been used to analyzechronicinflation in Brazil.
Two dominanttheories for price formationin an open
economy act throughpurchasingpower parity (PPP) and
money demand.The long-runrelationshipsare
p = ble + b2p*

(1)

m - p = b3y+ b4R+ b5Ap,

(2)

and

where p and p* are the logs of the domestic and foreign

price levels, respectively,e is the log of the exchangerate,
m is the log of the moneystock, y is the log of real output,
R is the interestrate,and A is the first-differenceoperator.
Ideally,I wouldanalyze(p,e, p*,m, y, R) as a single system andproceedfromthere.Becauseof the shortnessof the
sample,however,I adopt an alternativestrategy,which is
in the spiritof Juselius(1992). I first estimatethe preceding equationsseparatelyvia cointegrationanalysis.Then,

423

? 1998 American Statistical Association

Journal of Business & Economic Statistics
October 1998, Vol. 16, No. 4

424

Journalof Business & EconomicStatistics,October1998

15 -

12

14.8
8-

6-

14.6

414.4
1979

1975

1989

1985

1998

14. 2

14

13.8
a

. -.
- .--.:--.--.. ..---.-

...

.. .

................

13.6
1979

1975

1988

1985

1998

Figure 1. UpperPanel: the Log of the Price Levelp (

) and
the Log of the ExchangeRate e (.. ); LowerPanel:the GrowthRates
forthe Price IndexAp (-)
and the ExchangeRate Ae (. .).

1978

1975

1988

1998

1985

Figure2. TheLog of the PriceLevelMinusthe Logof the Exchange

) and the Log of the Foreign Price Level p* ((.).-

Rate p - e (

or very small, and that the other variablesonly affect the

to examine the relativeimportanceof these relationships rate of changeof inflation.
in determiningBrazilianprices,I developa single-equation The failurein 1986of the Cruzado
Plan,whichwas based
ECMfor inflationthatincorporatesfeedbackfrombothre- on the idea that inflationwas
inertial,however,
basically
lationships.The ECM is thus of the form
indicatedthat demanddoes play a role in the determination of inflationin Brazil (Cardoso1991). Relatedly,sevk-1
k-1
eral modelsin the monetaristtraditionof Harberger(1963)
Z
Apt = c + E riiApt-i +
wr2i4et-i
have
been appliedto Brazilwith some success(Cline 1981;
i=1
i=O
Hanson
1985;Barbosaand McNelis 1990). In these modk-1
k-1
k-1
4iAmt-i + 5riAlyt-i els, excess money supplyis the measureof excess demand.
+ S 3iAp*i + 5
In the pure monetaristmodels, only variablesenteringthe
i=O
i=O
i=O
k-1
money-demandrelationshouldbe significant,butotherver+ E 7r6iARt-i + al[p - bie - b2p*]t-1
i=O

+ a2[m - p - b3Y- b4R - b5Ap]t-1 + vt.

(3)

Equation(3) can be viewed as a general model of inflation that embeds several other models relevantfor the
periodof chronicinflationin Brazil.One importantmodel
comes from the inflation-inertia
hypothesis,which was developed after the failure of stabilization programs in the
early 1980s. According to this hypothesis, backward indexation of wages and accommodating monetary policy made
inflation insensitive to demand policies and mainly determined by its own history (Arida and Lara-Resende 1985;
Lopes 1986). The inertia was considered so large that negative shocks to inflation, such as the oil-price hikes in the
1970s, were believed to shift inflation to a new level, where
it would stay until a new shock occurred. Empirical studies of the Phillips curve and the finding of a random-walk
component in the inflation rate supported the hypothesis
of inertial inflation (Lara-Resende and Lopes 1981; Lopes
1982; Cardoso 1983a). The inertia approachwould thus predict that the coefficients on lagged inflation in (3) sum to
unity, that the variables related to demand are insignificant

.33
.3
.27
.24
.21

?18
.15

.63

1978

1975

1988

Figure3. The InflationRate Ap (--Rate e - p + p* (.. ).

1985

1998

) and the Real Exchange

Durevall:The Dynamicsof ChronicInflationin Brazil,1968-1985

425

Table1. Cointegration
Analysisof the ForeignSector
.089
rank< 1

.045
rank< 2

44.6**

9.6

2.8

29.7

15.4

3.8

.398
rank= 0

Eigenvalue
Nullhypothesis
Atrace

95%criticalvalue

Standardizedcointegrationvectorand adjustmentcoefficients
Variable

e-

Ap

p*

-.29
-.11

-.23
.57

1.00
-1.12

Cointegrationvector0
Adjustmentcoeff. a

Testsof the significanceof a given variableand of weak exogeneitya

Variable

e-

Ap

ExclusionX2(1)
WeakexogeneityX2(1)

p*

28.2**
1.78

26.7**
7.05*

28.5**
27.1**

Test of cointegrationbetween real exchange rate and inflation:X2(1) = 22.61 [.00]

Equation
AR:F(5, 45)
NormalityX2(2)
HeteroF(18, 31)

Ap
1.70 [.15]
1.40 [.50]
.83 [.65]

Misspecificationtestsb
e- p
p*
1.54 [.20]
.65 [.66]
1.11 [.57] 4.55 [.10]
.55 [.91]
1.04 [.44]

Jointtest
F(45, 98) = 1.11 [.33]
X2(6) = 8.32 [.22]
F(108, 156) = .90 [.72]

F tests forsimplificationfrom5 to 3 lags

F tests

p value

5 to 4: F(9, 102) = 1.19,

4 to 3: F(9, 109) = 1.14,

[.31]

[.34]

5 to 3: F(18, 109) = 1.17

[.30]

constanttermand centeredseasonal dummies,

NOTE:The vectorautoregressionincludesthreelags in each equation,an unrestricted
two impulsedummies,whichtake the valueof 1 forthe devaluationsin 1979:4and 1983:1,and fourimpulsedummiesin the equation
forp* that removeoutliersin 1973:1,1974:1,1974:3,and 1975:1.The estimationperiodis 1968:4-1985:4.Atraceis Johansen'strace
The nullhypothesisis in terms of the cointegrationrank,such that rejectionof rank= 0
eigenvaluestatisticfortestingcointegration.
vector.Criticalvalues are takenfromOsterwald-Lenum
is evidenceof at least one cointegrating
(1992,table 1). The asterisksindicate
significanceat the 95% (*) and 99% (**) level, respectively,where the statisticshave been adjustedfor degrees of freedomlost in
estimation.
a Exclusionand exogeneitytests are carriedout underthe assumptionof rank= 1.
b The misspecification
tests are againstthe alternativehypotheses-residualautocorrelation
(AR),skewness and kurtosis(normality),
and heteroscedasticity
(hetero).Hendry(1995) provideda descriptionof the tests. The p values are givenin brackets.

sions would predictthat importedinflationinfluencesdomestic inflation.In any case, a reasonablerequirementfor

the monetaristmodel to be valid empiricallyis that the
termfor moneydemandentersignificantly
error-correction
in (3).
A related issue regardsthe fundamental,or long-run,
causes of inflationin an open economy.Blejer andLeiderman(1981) incorporateda real-exchange-rate
policy rule in
a model based on the monetaryapproachto the balanceof
paymentsandappliedit to Braziliandata.Theyclaimedthat
the authoritiescan controlthe rate of inflationin the long
runby adjustingdomesticcredit;thatis, money servesas a
nominalanchor.In contrast,AdamsandGros(1986)argued
in a theoreticalstudythat the adoptionof a real-exchangerate rule leads to the loss of the nominalanchorand that
currentinflationthenbecomesequalto laggedinflation,just
like in the model of inertialinflation.
These two hypothesesare relatedto (3) in the following
way. If money is the long-rundeterminantof inflation,the
termfor the money marketshouldbe sigerror-correction
nificant.If thereis no nominalanchor,however,the parameters on lagged inflationshould sum to unity, and neither
terms should be significant.These
of the error-correction
tested
can
be
empirically.
hypotheses

2.

THE DATAAND COINTEGRATIONANALYSIS

In this section I use graphsto show some characteristics

of the dataand give some intuitionas to why cointegration
holds. I then test for cointegrationbetweenvariablesusing
the Johansen(1988) procedure.All numericalresults are
from PcGive 8.1; see Doornikand Hendry(1994).
The data used are quarterlyfor 1967:1-1985:4,and the
estimationperiodis 1968:4-1985:4unless otherwisenoted.
The analysis begins in 1968:4 because of a major devaluationin 1968:3before the adoptionof real-exchange-rate
targeting.The mainvariablesarethe generalpriceindex,P;
moneyplus quasimoney,M, as definedin the International
FinancialStatisticsdatabase;the interestrateon bills of exchange, R, expressedas In[l+ (%interestrate/100)];real
output,Y; the exchangerate, E, in cruzadosper U.S. dollar;andworldprices,P*, representedby the U.S. wholesale
price index. Details appearin the Appendix.
As reportedin several studies, nominal variablessuch
as the price level can be describedas 1(2) processes (see
Novaes 1993; Rossi 1993). Because cointegrationanalysis
with the Johansenmethod at the 1(2) level is still being
developedand is rathercomplex,I preferto transformthe
1(2) variablesto I(1) (see Johansen1995). For the foreign
sector, I thus get e - p, p*, and Ap as the relevant variables,
and for the money market, m - p, y, R, and Ap. I have in

Journalof Business & EconomicStatistics,October1998

426

.3

.2?

.218

*
12

"" :i

.99-

1970

1975

Figure4. The InflationRate Ap (

1988

1985

1999

) and the Velocityof Money

rejectsthe impositionof equalcoefficients.This is probably

an issue of high powerfrom the high variationin the data.
The variablesused in money-demandanalysis are depicted in Figures 4 and 5. Figure 4 shows that inflation
and the logs of velocity (p + y - m), scale adjusted,are
likely to forma cointegratingvector.Figure5 demonstrates
that the interestrate and inflationfollow each other over
time. Table 2 presentsthe formal tests for these relationships.
A VAR for (m - p, y, Ap, R) was estimatedwith four
lags, an unrestrictedconstantand centeredseasonaldummies, andtwo impulsedummies(1984:4and 1985:3)capturing policy-inducedshocksto the interestrate.Thereappear
to be two cointegratingvectors,as expected.The first one
looks like a money-demandrelation;thatis, the coefficients
of m - p and y are almost equal but with oppositesigns,
the coefficientof inflationis positive, and the adjustment
parameter(a) for m - p is negative.In the second vector,
as well as in the first, the coefficientsof the interestrate
and inflationhave similarvaluesbut oppositesigns. Moreover, accordingto the exclusiontests, which are all significant, each variableentersone or two of the cointegrating
relations.The misspecificationtests for the individualequations are insignificant,exceptfor the interest-rateequation,
in whichthe normalitytest is significant.The test for residual autocorrelationis significantat the 5% level but not
at the 1%level. Joint distributiontests also indicatesome
is not
butthe test statisticfor autocorrelation
nonnormality,
at
the
level.
5%
significant
To test whetherthe two cointegrationvectorscan be expressed as a money-demandrelationand the real interest
rate (a Fisherrelation),I carriedout a likelihoodratiotest.
As reportedin Table2, the restrictionsare accepted.I also
testedfor weak exogeneityand,somewhatsurprisingly,the
only weakly exogenousvariablewas inflation.This test is

Ae), with the log-levels adjustedto have equalmeans.The

log-levels and the growthrates follow each other closely,
andtheirshapessuggestI(2)-ness.Figure2 (p. 424) depicts
boththe priceminusthe exchangerate (p- e) andthe mean
adjustedlogarithmof world prices (p*). ApparentlyPPP
holds well to 1979, when it breaksdown.Figure3 (p. 424)
graphsinflation(Ap) and the scale-adjustedreal exchange
rate(e+p*-p). This figureindicatesthatdynamics,through
the steady-statesolution,recoverPPPas a long-runsolution
for the whole sample.
Table1 (p. 425) reportsresultsfromthe applicationof the .3Johansenprocedureto the foreign-exchangesector,involv.27
ing (Ap, e - p, p*). The vector autoregression(VAR)contains threelags, an unrestrictedconstantand centeredsea- .24
sonaldummies,impulsedummiesfor the maxi-devaluations
in 1979:4and 1983:1,andfourimpulsedummiesto improve .21the specificationof the regressionon worldprices (1973:1,
1974:1,1974:3,and 1975:1).The last four dummiesdo not .18
alter the overallresults of the analysis,but they make all
.15
the misspecificationtests insignificant,as shownin Table1.
The numberof lags was determinedwith F tests, simplify- .12
ing from a VAR(S)to a VAR(3).
The tracestatisticfor rank= 0 is significant,but not for
rank s 1, so there appearsto be one cointegratingvector.
All the variablesare statisticallysignificantin the cointe?03gratingvector,as shownby the significanceof the exclusion .63
tests, and only the world price level is weakly exogenous,
accordingto the tests for weak exogeneity (see Johansen
1975
1978
and Juselius 1990 on these tests). All the signs of the coefficientsare as anticipated,and the values of coefficients
Figure5. The InterestRate R ( for e - p and p* are very similar.A formaltest, however, (- .).

::

1988

1985

1998

) and The InflationRate Ap

Durevall:The Dynamicsof ChronicInflationin Brazil,1968-1985

427

Table2. Cointegration
Analysisof the MonetarySector
.370
rank= 0

Eigenvalue
Nullhypothesis

.360
rank< 1

.091
rank< 2

.088
rank< 3

Atrace

75.6**

43.7**

12.9

6.3*

95%criticalvalue

47.2

29.7

15.4

3.8

Standardizedcointegratingvectorand adjustmentcoefficients
Variable

m- p

Ap

Cointegratingvectors 3

1.00
-1.19
-.18
-.80

-1.15
1.00
.06
-.05

7.84
4.58
-.01
-.01

-6.66
-5.28
-.01
-.01

Adjustmentcoefficienta

Tests of the significanceof a given variableand of weak exogeneity

Variable

m- p

ExclusionX2(2)
WeakexogeneityX2(2)

15.39**
18.18**

16.20**
9.64**

Ap

25.35**
.83

19.25**
10.93**

Restrictedcointegratingvectorsand adjustmentcoefficients
Variable

Cointegratingvectors 3
Adjustmentcoefficienta

m- p

Ap

1.00

-1.00

.96
6.92
-.02
.01

-.09

.11

-6.92
-.00

Test for restrictedcointegratingvectors:X2(2) = 4.44 [.11].

Misspecificationtests
R
m- p
y
Equation
Ap
AR:F(5, 42)
2.08 [.09]
.75 [.59]
3.80 [.01]
1.01 [.42]
2.45 [.29]
.60 [74]
.05 [.98]
29.40 [.00]
NormalityX2(2)
.58 [.90]
HeteroF(32, 14)
.63 [.86]
.29 [.99]
,93 [.58]
F tests forsimplification
from5 to 4 lags: F(16, 122) = .620 [.862].

Jointtest
F(80, 97) = 1.41 [.053]
X2(8) = 21.64 [.006]
F(320, 75) = .39 [1.00]

NOTE:The VARwas estimatedwithfourlags, an unrestricted

constantand centeredseasonal dummies,andtwo impulsedummies(for
1984:4and 1985:3),capturingshocksto the interestrate.See Table1 formorenotes.

The estimatedparametersand the misspecificationtests

not invariantto inclusionof I(0) variables,however.Likewise, weak exogeneityin the full system (p,e, p*,m, y, R) of the model are reportedin Table 3. To start with, five
may differ from weak exogeneity in the two subsystems lags were used, but F tests indicatedthatthe model could
examined.
be simplifiedto threelags. When the model was estimated
with ordinaryleast squares(OLS),the parameterof A2mt
was negativeand significant.Because this could be due to
MODELOF INFLATION
3. A DYNAMIC
simultaneitybias, the model was reestimatedwith instruIn Section 3.1 I develop an ECM of inflationusing the mental variablesfor A2mt, where the added instruments
general-to-specificmodelingapproach,andin Section3.2 I were A2mt_4 and lags 1 to 4 of the second differenceof
of the preferredmodel. the
discussthe economicinterpretation
log of high-poweredmoney,A2hpm. The result was a
In Section3.3 diagnostictests areusedto checkfor omitted small increasein the t
value, makingthe estimatedcoeffivariables.Finally,Section 3.4 analyzesthe model'sempir- cient
of A2mt insignificant.Thatmodelwas also estimated
ical constancy.
assumingthat A2et was endogenous,but there was little
change in the parameterestimates.As reported,the spec3.1 Developmentof the EmpiricalModel
ificationtest for the validity of the instrumentalvariables
I beginby specifyinga generalunrestrictedECMandtest is insignificant,and there is no evidence of misspecificafor whetherit is well specified,with white noise, normally tion of the model. Most of the individualcoefficientsare
distributedresiduals,and so forth. The variablesentering of little interestin themselves.Those of the lagged levels
the model are the seconddifferencesof the price level, the of the variablesof the foreign sector are clearly signifiexchangerate and the money stock, the first differenceof cant, however,but those belonging to money demandare
outputand the interestrate, and the variablesenteringthe insignificant.
Next, the numberof parametersin the general model
cointegratingvectors, lagged one period. Moreover,I include the second differenceof the log of the oil price in was reducedto obtain a parsimoniousmodel. The stratU.S. dollars,op*,to accountfor the oil-priceshocks in the egy followed was to delete insignificantparametersin
1970s. All regressionsreportedhave a constantand cen- steps startingwith those that are obviously 0, and to test
both for the specificationof the model and for whether
tered seasonaldummies.

Journal of Business & Economic Statistics, October 1998

428

ModelforInflation
Table3. GeneralError-Correction
Lag i
Variable
A2pti

0
--1
(-)

-.112
(.239)

-.174
(.169)

-.137
(.152)

A2et-i

.252

.132

.079

.042

AP* i

(.044)
.276
(.280)

(.053)
-.021
(.239)

(.047)
-.237
(.238)

(.041)
-.189
(.202)

-.179

-.084

A2mt_i

-.154

(.074)
Ayt-i
ARt-i

A2oP?_i

-.142

.040

(.108)

(.102)

.165

.400

(.174)
.008
(.015)

(.195)
.034
(.015)

(.082)
-.110

(.092)
-.192

(.264)
.020
(.017)

.006

(.071)
-.010

(.109)
1.357

(.378)
.011
(.020)

-.472

Apt-i

e - pt-i
pt-i
m - pt-i
yt-i
Rt-i
Sit

(.076)

1.819
(.504)

(.235)
.191
(.038)
.200
(.054)
.028
(.041)
.016
(.071)
-.247
(.159)
-.020
(.021)

1.12, hetero:F(15, 43) = .53, Chow test of parameterconstancy 1982:1-1985:4:F(16,42) = 1.55,F test for simplificationfrom three lags: F(27, 32) = 1.15, and F test
for adding (m - p - y + .96Ap)t_- and (R - Ap)t_l:
F(2, 57) = .015[.9853].

Apartfrom the seasonalsand the constant,(4) contains

only six explanatoryvariablesrelativeto the 33 thatentered
the generalECMin Table3, and the standarderroris only
.04%higher.Moreover,the regressorsarerelativelyorthogonal. The highest correlationcoefficientis .58 in absolute
value, and thereare only two othercorrelationsabove .20.
All the estimatesare clearlysignificantat the 5%level, except the one for outputgrowth,whose t valueis somewhat
below 2. Outputgrowthwas kept in the model becauseit
affectsthe model'sstability.Surprisingly,neithercointegration vector from the monetarysector appearssignificant:
F(2, 57) = .015[.9853].

3.2 EconomicInterpretation
To facilitatethe interpretation
of my model,I can rewrite
it by addingand subtractinginflationlagged one periodto
get
Apt=
-.008
(.017)

-.013
(.015)

NOTE: The dependentvariableis A2pt, Sot is the constantterm,and Sit, S2t and S3t are
centeredseasonaldummies.Standarderrorsaregiveninparentheses.Thetests reported,apart
fromthose listedinTable1, aretests forresidualautocorrelation
(dw),autoregressiveconditional
heteroscedasticity
(ARCH),nonlinearity
(RESET),and specificationtest forthe validityof the
instrumentsused for the IVestimation(IVspecificationtest). MethodOLS, T = 69 [1968:4from5 to 3 lags: F(14, 18) =
1985:4];R2 = .90; standarderror= .0127;F test forsimplifying
1.13 [.40];AR;F(5, 27) = .48 [.78],dw = 2.14; ARCH:F(4, 24) = .64 [.64];normality:
X2(2)
= 1.85 [.39];RESET:F(1, 31) = 1.73 [.20],IVspecificationtest: X2(4) = 1.41 [.84] (additional
instrumentsused are A2mt-4, and lags 1 to 4 of A2hpm).

any of the excluded variables are differentfrom 0. Ericsson, Campos, and Tran (1990) gave a good description of this modelingstrategy.In simplifying,threetransformationswere made:Currentand lagged exchange-rate
variableswere aggregatedwith relative weights of 2 to
1 (a simple Almon polynomial);an error-correction
term

was formed with Aptl,,e - pt-1, and p* 1; and ARt-3

was subtractedfrom ARt-2. The following highly par-

simonious and statistically acceptableECM was finally

obtained:

.41Apt1

+ .28 (2A2et

A2et-1

+ .06A2mt-3 - .08Ayt-2 - .57A2Rt_2

+ .03A22op*t1 - .15(p - e - 1.2p*)t-i,

(5)

wherefor simplicityI leave out the deterministicvariables

and the error term. Equation(5) refutes the inertial hypothesis that the inflationaryprocess is best describedby
a random-walk model. The coefficient on lagged inflation

is only .41, and the price level enterswith a negativecoefficient.Moreover,laggedinflationis likely to capturethe
effectsof expectationsandotherindexationschemesas well
as wage indexation.Thus,in Section 3.3 I test directlyfor
whetherwages contributedto inflation.
Moneyonly entersthe modelin seconddifferences.A 1%
increasein the rateof changeof the moneysupplyincreases
inflationby about.06%.Moneyinfluencesinflationonly in
the shortrun,andconsequently,thereis no supportfor the
view thatexcess supplyof moneyis the basic drivingforce
of inflation.

The rate of devaluation, oil-price shocks, output growth,

and the second difference of the interest rate also influence the short-run movements in inflation. All four vari(.043)
ables have coefficients with the expected signs. Thus, the
- .080Ayt_2
- .567A2Rt2 + .032A20p_1l
short-run effect of a one percentage point increase in the
(.053)
(.108)
(.010)
rate of devaluation is a rise in inflation of .28%. A one percentage point increase in the growth rate of oil-price infla- .594(Ap - .257(e - p) - .308p*)t-I + 1.499
tion increases general inflation by .03%, and a 1% higher
(.088)
(.222)
output growth lowers inflation by .08%. The impact of a
unit
change in the second difference of the interest rate is
+ .003Slt + .002S2t - .002S3t
.57%.
This value is only valid for the final year of the sam(4)
(.008)
(.006)
(.009)
ple, however, as shown in Section 3.4.
where T = 69 [1968:4-1985:4], R2 = .81, standard erThe most interesting variable in the equation is the errorror = .0131, AR: F(5, 54) = .95, dw = 1.90, normality: correction term, which is associated with the PPP relation.
Although there are different ways of interpreting errorX2(2) = .63, ARCH: F(4, 51) = .65, RESET: F(1, 58) =
A2p, =

.281 (2A2t + 2et-1)

+ .058A2mt-3
(.023)

Durevall:The Dynamicsof ChronicInflationin Brazil,1968-1985

429

Table4. DiagnosticTestsforOmittedVariables
Variables

Sample

F test

(hpm- p)t-1
A2hpmt
(m3 - p)t

Yt-1
A2hpmt_
Yt-1

Rt-1
A2hpmt-2
Rt-1

APt-1
A2hpmt-3
Apt-1

Ahpmt-1
A2hpmt-4
Am3t-1

72:3-85.4

A2m3t
(w - p)t-1
A2 Wt-1

A2m3t_-1
prodt
A2 Wt-2

A2in3t2
awt-1
A2 Wt-3

A2m3t_3
Apt-1
A2Wt-4

71:1-85:4

A2apt

A2apt-i

A2apt-2

A2aPt_3

A2m3t-4
A2wt
SWO-2t
A2aPt-4

68:4-85:4

(y-trend)t

(y-trend)t-1

(y-trend)t-2

68:4-85:4

(y-strend)t

(y-strend)t-1

(y-strend)t-2

68:4-85:4

(y-hptrend)t

(y-hptrend)t-1

(y-hptrend)t-2

68:4-85:4
71:3-85:4

F(10, 49) = .858

[.578]
F(10, 38) = 1.146
F(12, 32) =

[.356]
.941
[.520]

F(5, 45) = 1.988

[.092]
F(3, 56) = .505

[.680]

F(3, 56) = .523

[.668]
F(3, 56) = .774
[.513]

NOTE: SWo_2tis a seasonal dummyintendedto capturethe change in seasonalityin the wage series. It is 0 up to 1977:4.prod is a proxyforproductivity,
y-trendis outputdetrendedwitha
filter.
lineartrend;y-strendis outputdetrendedwitha segmentedtrend,wherethe breaksare in 1974:2,1979:4,and 1983:3;and y-hptrendis outputdetrendedwiththe Hodrick-Prescott

is as an approxcorrectionterms,the most straightforward

imationto the deviationaroundthe long-runreal exchange
rate.Accordingly,when the real exchangerateis undervalued, inflationgoes up, and when it is overvalued,inflation
goes down.
The feedbackparameteris relativelysmall, -.15, which
shows that the adjustmentis slow toward static-state
equilibrium-thatis, when all prices are constant.By comparison,the adjustmentto a steadystate-that is, whereall
prices grow at a constantrate-is relativelyfast because
the value of the feedbackparameteris -.59, as shown in
Equation(4). A similarresult is obtainedby de Brouwer
and Ericsson(1998, in this issue) in a study of Australian
inflation.
3.3 DiagnosticTests
In this subsectionI test for omittedvariables,including
othermeasuresof money,wages, the outputgap, andprice
.6-

.4

.
.....
.........

-.3

...................

-..4

1975

1989

1985

1999

) and the
Figure6. The Log of the Real WageLevel w - p (
Trendof the Log of OutputCalculatedWiththe Hodrick-PrescottFilter
prod (.-.).

tests are calculated

shocks in agriculture.Omitted-variable
on subsetsof variables:Degreesof freedompreventus from
looking at all these variablesjointly.
Becausethe definitionof money might be importantfor
the results, Table 4 reportsF tests for addingthe log of
eitherhigh-poweredmoney (hpm) or of M3 (m3) to Equation (4). Insteadof going throughthe Johansenprocedure
again,I enteredthe variablesdirectlyinto (4). To allow for
multicointegration-thatis, cointegrationbetween a linear
combinationof 1(2)variablesthatform an I(1) variableand
the firstdifferenceof these variables-I also addedthe rate
of changeof hpm and m3. Moreover,to captureshort-run
effects, four lags of the second differencewere included.
The F tests are insignificantin both cases.
Wages and wage indexationhave played a centralrole
in the discussionof inflationin Brazil,so I tested whether
wages enter(4). Datafor the labormarketposes a problem,
however.Quarterlywage data do not exist for the whole
estimationperiod,so the longest series availablewas used.
It startsin 1971:1 and covers the manufacturingindustry.
Data on the level of productivityare not available,so as a
proxyI usedthe trendof outputobtainedwith the HodrickPrescottfilter.It capturesthe trendin the real wage quite
well, as shownin Figure6. Thus,to test for an effect from
the labormarket,I includedthe real wage level, w - p, the
proxyfor productivity,prod, wage andprice inflation,four
lags of the seconddifferenceof the wage level, andsubsample seasonaldummiesto capturethe changein seasonality
in the wage series in 1978 (see Fig. 6). As reportedin Table 4, the F test for these variablesis not significant.This
result is surprising,consideringthe large numberof theoreticalstudieson wage-pricedynamicsin a settingof wage
indexation.Severalattemptswere thereforemade to find a
significanteffect fromwages,going throughthe general-tospecificprocedureagainfor the subsample.The resultwas
the same,however,which supportsBaer'sclaim that wage
mechanism
policy was not a strong inflation-propagating
(Baer 1989, p. 148). It shouldbe remembered,though,that
theremightbe largemeasurementerrorsbecausethe series
for the wage level andproductivityarereallyboth proxies.
Earlierstudiesof the Phillipscurvefailed to find a clear
effect of excess demandon inflation.This mightbe caused

430

Journalof Business & EconomicStatistics,October1998

4 "

Constant

t_

3........

1982

1978
1.2

..

et

A2Rt.2 =

.3

1986

1978

1982

z~1------

----

1978

-.

1986

P
... -.

1978

1982

1986

1982

1986

One-stepresiduals=

.04

eop

.04

...,

..

V-

4VV_

----------_____

1982

1978

1986

1986

1982

1978
16

WOne-step

Chows =

.08,

Z~

..--------.IZL

4L

-..
1978

1982

1988

.2

1978

1982

1986

1978

1978

1982

1986

1978

Break-point Chows =

1986

.28

1978

1982

1986

1982

1986

Figure 7. Recursive Estimates of the Coefficients of the Parsimonious ECM Model With + 2 Estimated Standard Errors (. .), One-Step
- and One-Step-Ahead Chow Statistics and Breakpoint Chow Statistics Scaled With Their 1%
Residuals With Corresponding Standard Errors ( .),
Critical Values. The straight lines at unity show the 1% critical level

by usingdeviationsof outputfroma lineartrendas the measure of the outputgap. Tombiniand Newbold (1992), for
instance,arguedthat the Braziliangross domesticproduct
(GDP)containsstructuralbreaks.To investigatewhetheran
augmentedPhillipscurvecan be obtainedfor Brazil,I used
three differentmeasuresof the outputgap as proxies for
excess demand-the deviationsof the log of outputfrom a
lineartrend,y-trend;the deviationsfroma segmentedtrend,
y-strend,as in Gordon(1988); and the deviationsfrom a
trendobtainedwith the Hodrick-Prescottfilter,y-hptrend,
usedby Chadha,Masson,andMeredith(1992).Currentvalues and two lags of each of the three proxies for excess
demandwere addedto (4). None of the variableshave significantcoefficients(Table4).
Finally I checked whetheragriculturalprice-shocksaffected inflation,as arguedby Marques(1985). Fourlags of
the seconddifferenceof the log of the price of agricultural
products(A2ap) were entered.As in the previouscases, the
F test is insignificant.

(Cardoso1991). In practice,it works like a dummyfor a

few observationsin our model, and it is a good example
of the risk associatedwith relying exclusivelyon t values
withoutfirstcheckingthe stabilityof the parameters.
Furtherinformationon the stabilityof the model can be
obtainedfrom the three last plots in the right column in
Figure 7. The first one shows the one-step residualsand
the correspondingcalculatedstandarderrors for (4). All
residuals are within the confidenceintervals,thus showing no evidenceof coefficientchangesor outliers.The two
final graphspresentthe sequentiallyestimatedone-periodaheadChowtest statisticsand breakpointChowtest statistics, scaled by their 1%criticalvalues. The 1%level was
chosenratherthanthe 5%level to help controloverallsize,
notingthatthese are sequentialtests over roughly40 observations.In no case are the tests significantat the 1%level.
Hence, I concludethatthe overallstabilityof the model is
fairly good.
4.

3.4 ParameterConstancy
In this subsection,I investigatethe stabilityof the model
using recursiveestimation.The volume of outputis large,
but it can be efficiently summarizedin graphs. Details
aboutrecursiveestimationand stabilitytests were given by
Hendry (1995).

Figure7 plots the recursiveestimatesof the coefficients

in Equation(4) and ?2 estimatedstandarderrors.Most of
the parametersare reasonablystable.The exceptionis the
coefficientof the interest rate, which oscillates around0
until the end of the sample in spite of having a t value
of -5 over the whole sample.This is broadlyconsistent,
however,with the view that the interestrate first becomes
importantfor the dynamicsof inflationafterthe debt crisis

SUMMARYAND CONCLUSIONS

This studyinvestigatedthe inflationaryprocessin Brazil

for the period 1968:4-1985:4.The model should not be
viewed as a finalproductbut as partof whatHendry(1995,
p. 550) calleda progressiveresearchstrategy,in whichnew
models improveand encompassold ones. Nonetheless,the
model does convey interestinginformation.Our key findings are as follows.
The degreeof inflationaryinertia,as indicatedby the coefficientvalue of lagged inflation,is only .41. This is much
less than that obtainedfrom other studies and much less
than what is assumedin many theoreticalmodels. Moretermwith a
over,the price level entersthe error-correction
that
less
than
40% of an
which
implies
positive coefficient,
increasein inflationis transmittedto the nextperiod'sinfla-

Durevall:The Dynamicsof ChronicInflationin Brazil,1968-1985

tion. The actualsize of inertiathus dependson the time it

takes the exchangerateto adjustto an increasein inflation.
Accordingto Blejer and Leiderman(1981), it took as long
as a year duringthe 1970s.
Inflationis drivenby the error-correction
term, consisting of the price level, the exchangerate, and worldprices.
This relationcan be interpretedas showingdeviationsfrom
the equilibriumreal exchangerate. Thus, in the long run,
domestic prices are determinedby the exchangerate and
world prices. Moreover,there is no evidence that excess
moneysupplyis the directcauseof inflationnorthatmoney
is a nominalanchor.The importanceof the foreign sector
for the rate of inflationis surprising,consideringthe size
of the Brazilianeconomyandthatthe importshareof GDP
was below 10%duringmost of the years in the sample.
It was not possibleto detectany effectson inflationfrom
the three measuresof excess demandin the goods market
that I constructed.Moreover,I failed to find any directeffect on inflationfrom wages. The qualityof the wage and
productivityvariablesused, however,calls for cautionregardingthese results.
In terms of dynamics,an increasein money growthor
oil-price inflationincreasesoverall inflation.Moreover,as
expected,inflationincreaseswhen the rate of devaluation
of the exchangerateincreases,andinflationdecreaseswhen
outputgrowthgoes up. Thereseemsto be no effecton inflation from changesin the interestrate until the mid-1980s,
when it had a strongnegativeimpact,albeitwhile not having any long-runeffects.
ACKNOWLEDGMENTS

431

I also tried the parallelexchangerate and trade-weighted

exchangeratesandforeignprices,but the resultswere less
satisfactory,thoughnot substantiallydifferent.
Oil Price. The oil-price index (OP*) is for Kuwait
crude,IFS line 44376aad.
InterestRate. The interestrate (R) is on three-month
bills of exchange,takenfrom Rossi (1988).
Real Output. The index for real output (Y) was computedby Cardoso(1983b)up to 1979 from quarterlydata
on cement production,industrialelectricity consumption,
motor-vehicleproduction,and the real revenueof the National Treasury.From 1980, the series is the officialGDP
publishedby FundaqioInstitutoBrasilerode Geografiae
Estatistica(IBGE).
Wages. The wage series (W) is takenfrom Estatisticas
Historicasdo Brasil (1988), publishedby IBGE. It covers
the manufacturing
industry.Comparisonswith othershorter
wage seriesthathavea widercoverageshowlittledifference
betweenthe series.
AgriculturalPrices. The price index for agricultural
products(AP) was suppliedby FundaqaoGetulioVargas.
[Received December 1994. Revised December 1997.]

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