FINANCIAL CAPITAL IN A CGE MODEL FOR

BRAZIL: FORMULATION AND IMPLICATIONS*

†
Wilfredo Leiva Maldonado
‡
Octávio Augusto Fontes Tourinho
Marcos Valli§

(Preliminary version)

*
The analysis, interpretation, conclusions and opinions contained in this document are
exclusively those of the authors, and do not represent those of the institutions to which they are
or were associated.
†
Of Universidade Católica de Brasília. This author thanks the financial support of for this
research from CNPq, through scholarships PQ 305317/2003-2 and Edital Universal no.
471899/2003-8, and of IPEA, BID and PNUD, through project RedeIPEA no. 31F19/J-CBR
4339/2005.
‡
Of Banco Nacional do Desenvolvimento Econômico e Social. The participation of this author
in this research occurred under the technical cooperation program between BNDES and IPEA,
for years 2006 and 2007.
§
Of Banco Central do Brasil
1 INTRODUCTION
Computable general equilibrium models (CGEs) have been used in several countries to
analyze the costs and benefits of a varied range of public policies, especially those of a
fiscal nature and those directed towards foreign trade, income distribution and
stimulation of economic growth. A systematized account of the main studies can be
found, for example, in the two main surveys published more recently: Gunning and
Keyzer (1995), and Ginsburgh and Keyzer (1997).
In general, these studies have used the comparative static methodology to address
the themes listed above. That approach calculates the impact of economic policy
measures on the stationary state of the economy, leaving aside the analysis of the
transitional dynamics between the current and the new stationary states.
To address the impacts on economic growth it is frequently necessary to use
dynamic versions of the CGEs, which simulate the economic equilibrium for several
successive moments in time, which are linked recursively though the trajectories of the
state variables, that usually are the stocks of the several types of capital and labor
considered in the model. However, it is not indispensable to use a dynamic model for
that purpose because, as shown in Rutherford e Tarr (2005), those issues can be
addressed in the realm of static models, as long as certain conditions are met and
attention to certain details is given throughout the analysis.
Regardless of which type of model is used, however, is of fundamental importance
that the equations of the model reflect the process of physical capital accumulation as
realistically as possible for the model to be able to simulate correctly the workings of
the real economy. It is in this respect that this paper proposes an advance with respect to
conventional CGE’s, by recognizing the bidirectional interaction between the allocation
of physical and financial capital in a modern economy. We show that this effect can be
addressed in the realm of a computable general equilibrium model of the Brazilian
economy which, extended to incorporate the financial system, provides an adequate
framework to treat it endogenously.
The inclusion of financial mechanisms in general equilibrium models has already
been discussed in other papers that studied the economic effects of the globalization of
international capital flows. These are briefly discussed below.
The impact of globalization on economic growth of developing countries was
studied by Prasad, Rogoff, Wei and Kose (2004), exploring, in particular, the effects of
a large and increasing private foreign capital inflow. They conclude for the absence of
strong evidence that it has affected the growth rate of the majority of those countries.
However, they find that countries that had: i) solid financial institutions; ii) good quality
Government, that is politically stable and honors contracts; iii) macroeconomic stability;
iv) fiscal discipline and, v) flexible exchange rates, display a large positive impact of
foreign capital flow on growth. Kose, Prasad and Terrones (2003) show that in the in
the 90´s private consumption in Americas developing countries did not accompany the
increase in global financial integration, as could have been expected if the increased
financial flow had reduced, through diversification, their macroeconomic risk.
Roland-Holst (2001) advances these efforts to model the financial transmission
mechanism, and disaggregates them by type and suggests several alternative
formulations for each one of them, especially for foreign direct investment and reserves

2
flow, which he considers to be the structural elements. Goodhart, Sunirand and
Tsomocos (2004, 2005) emphasize more the modeling of international financial flows
and its effects, and disaggregate net investments by type of investor, discriminating
banks, firms and the rest of the world. In addition, they take into account the possibility
of default, and show that it can generate financial fragility.
Taking the suggestions contained in these papers into account, and extending them,
Maldonado, Tourinho and Valli (2007) propose to treat foreign capital flows in a CGE
model for Brazil as endogenous, using a function linking it to the expected rate of loss
of foreign reserves which is based on empirical evidence for that country over recent
years. To quantify the importance of adding this feature to the model, they simulate the
impacts of the country joining free trade agreements, and compare them with the
response of the model with exogenous capital flows. They conclude that the impacts in
the extended model is significantly larger, lending support that the hypothesis that the
existence of the financial flow amplifies the impact of policies. That feature is a linkage
between the financial and the real sector of the economy, to the extent that foreign
investment is part of the country’s capital formation.
The objective of the research reported in this paper is to extend this line of research
and model the workings of the financial market in the Brazilian economy, is such a way
that it can be included in a larger general equilibrium model, and to determine the
importance of this extension by simulating shocks to financial and fiscal parameters.
We are specifically interested in identifying the real effects of changes in interest
rates. This issue is of special interest in the Brazilian case because of the preponderant
role of the State in the economy, which reinforces that interaction for two reasons. First,
because it is the main issuer of net debt in the country, it regulates the volume of credit
and determines the floor of the basic interest rate, which is the rate of return of public
bonds. Second, it has a large impact in the financing of capital formation in the country,
through the operational policy of public banks that subsidize credit.
To take into account the role of financial capital of firms and individuals, the model
recognizes explicitly that variations in these stocks imply endogenous capital flows that
can both affect the allocation of investment and be affected by it, interacts with other
endogenous variables, and is affected by the model’s parameters. At the aggregation
level employed by CGE models, this implies endogenous capital flows between the
sectors of the economy, and between the country and the rest of the world, which
condition investment and the physical allocation of sector capital and labor and,
therefore, economic growth.
The model, enriched by the financial flows, serves as an instrument to design
strategies to reduce the very high real interest rate of the Brazilian economy, and answer
at least tentatively that recurring issue in academic debate and current economic policy
in Brazil. In addition, it also allows us to calculate the capital movements that occur
when fiscal or monetary policy change, and thereby anticipate problems that may be
produced by their implementation.
The analysis here is developed in three stages. Initially we describe the technology
of the financial markets to collect and distribute savings, intermediating capital in the
economy. This implies relationships between the stocks of financial and physical capital
and their rates of return for the several agents. Next, functions representing these
relations are introduced in a Computable Equilibrium Model (CGE) for the Brazilian

3
economy which had previously been developed, 1 to extend it in the sense of creating a
transmission channel between the financial and productive sectors. Finally, we simulate
some fiscal and monetary policy shocks, and analyze their impacts to evaluate the extent
to which that model of the channel was satisfactory.
The main conclusion is that the existence of a developed capital intermediation
sector, like the one in the Brazilian economy, substantially increases the real impact of
some economic policies. The policies whose impacts are most affected are those related
to the credit supply and to the level of the interest rates.
The paper is composed of this introduction and 4 sections, described below. Section
2 describes how the financial intermediation sector relates to the other entities which are
usually represented in a CGE model, showing how we built the Financial Social
Accounting Matrix (SAM-F). Section 3 describes the model, emphasizing how the
financial market was modeled through a capital intermediation technology, and the
manner in which its supply and demand of capital were incorporated in the model as a
whole. Section 4 shows some simulation experiments. The last session summarizes the
main conclusions.

2 THE FINANCIAL MARKET

In this section we describe how the financial market appears in the representation of
our economy. This is done by showing how we built the Financial Social Accounting
Matrix (SAM-F) for Brazil in 2003. It consolidates the data base for our CGE model in
a consistent and systematic way, and registers the factor incomes, the flow of payments
between the several sectors and agents of the economy, the savings and investment
decisions, as well as changes in the assets and debts of the capital intermediation fund
that represents the financial markets. The reference year for this study is 2003, which
was the last one for which complete information was available at the beginning of the
research reported here.

2.1 DESCRIPTION OF THE SAM-F

The starting point for the modeling exercise in the next section is a very aggregate
version of the usual social accounting matrix (SAM), then it is extended to make
explicit the financial flows and their interaction with the savings flows which are
generated in the real part of the economy.
A social accounting matrix (SAM) is an account, in matrix form, of all the
transactions in a given economy in its reference year. It shows all the income and goods
flows, in disaggregate and consistent form, highlighting the interdependence that exists
between the several entities in the economy. It does that as it describes how goods and
factors are transformed, as they go from production, to the markets, to the institutions
and finally to the agents, and simultaneously registers the circular flow of income
between these entities.
A general description of SAM and its application to Brazil can be found in Silva,
Tourinho e Alves (2006), which contains a detailed and complete discussion of its

1
The CGE model is an extension of the model built initially by Sherman Robinson in a consulting conrtract for BNDES in
1996. Its formulation is similar to the model in Dervis, Melo and Robinson (1982), Devarajan, Lewis and Robinson
(1991), and Robinson et al. (1999).

4
structure and components, as well as a description of how to construct it from the
Brazilian national accounts. That paper also presents the SAM for 2003 in the usual
format, without the financial system accounts.

THE ENTITIES REPRESENTED IN THE SAM-F

The productive sectors are consolidated in only two categories: the financial and
non-financial enterprises. This large degree of aggregation is one order of magnitude
larger than the one which is usually adopted in CGE models for Brazil, that contemplate
about 40 sectors, and its adoption can be seen as an effort to develop a simple prototype
model of how to incorporate the financial markets in a conventional CGE model. It was
also adopted to allow the recovery of information regarding the flows in the financial
markets, for which detailed sector information does not exist.
The financial sector, as defined in the Brazilian national accounts (IBGE (2004)), is
formed by financial enterprises and institutions that dedicate primarily to financial
intermediation, or to ancillary financial activities strictly linked to it. On the other hand,
the non-financial sector is the set of private and public enterprises that produce
mercantile goods and services.
The two stages of the process of bringing the goods and services to consumers are
represented in the following way: production proper is represented by the activities,
while commercialization (in a broad sense) is represented by the markets, which is a
separate entity in the SAM.
The agent we denominate “families” in the SAM-F, and also in the CGE, includes
not only the families proper, but also the agricultural and cattle-related establishments,
micro-enterprises, the autonomous labor, the rent of owner-occupied residential real
estate, non-mercantile private services (domestic services and non-profit enterprises).
This aggregation requires, no doubt, heroic assumptions, but they are no less dramatic
then those required to consolidate all non-financial enterprises in a single group.
There are also two other agents: government and the rest of the world. The
government produces public goods at the activities at the federal, state and municipal
levels, and corresponds to the public administration sector in the national accounts. Its
main income source is the tax revenue. The rest of the world buys and sells goods and
services from the markets, and also invests in the country.
For each entity listed above there is a line and a column in the SAM-F. Throughout
a column for an entity, are registered all the payments made by it to each entity
(including itself) indicated in the corresponding line. The value of the flow is found in
the intersection of column and the line and, in the real side of the economy, corresponds
to a flow in opposite direction of goods and services. Over a line corresponding to a
given entity, therefore, all payments received by it are found. The equilibrium between
income and expenditure of each agent requires that the total of each column be equal to
the total of the respective line.
The SAM 2003 in Silva, Tourinho e Alves (2006) is consolidated, by summing
columns and rows, to reproduce the institutional framework described above, and yield
the cells in the conventional part of the SAM-F in Table 6.

5
PROPERTY INCOME AND CAPITAL INTERMEDIATION

As this framework outlined above is extended to include the financial markets,

additional payments between agents corresponding to loans, reinvestments, payments,
payment of interest and dividends, and other transactions with financial capital, which
are represented by cells in rows and columns which are added to the SAM. This
produces the SAM-F, where the equality between line and column totals represent the
budget balance of agents including these operations related to the financial capital.
Since these flows are usually not disaggregated in the standardized national accounts,
supplementary information has to be used to build the financial part of the matrix.
The SAM-F includes a current account to discriminate the remuneration of financial
capital, which is constituted by the part of the agent’s net wealth which lent to other
agents. It appears in the “Contas Econômicas Integradas” (IBGE (2004)) as income
from property, which is the rental paid to the owners of financial assets, or non-
produced assets, in return for its use. There they are classified in categories, depending
on the fact that generates the liability, as: interest,2 dividends and outlays,3 revenue of
holders of insurance policies, and income from land and underground exploration rights.
These items are not distinguished despite the fact that may have very different
determinants in the real world.
To represent them in the SAM-F it was assumed that the rental of financial capital
between agents is necessarily done through a financial intermediation fund. This
hypothesis ignores the existence of other mechanism of direct transfer of resources, but
it is made because it simplifies the representation of these flows in the model, and
because it reflects the organizations of modern market economies. Since all financial
capital transits through the fund, it will henceforth be denominated intermediated
capital.
The intermediation fund transfers savings between economic agents. The rental of
this capital appears in the SAM-F as a cell that represents a transfer between these
agents.4 The values paid by the intermediation fund appear in the column that represents
it, while the values received by it appear in the corresponding line, as with other
institutions in the SAM. The fact that the sum of the values in the column is equal the
sum of the values in the line indicates that the net transfer performed by the financial
system is null.

2
Interest is the remuneration of time deposits, fiduciary titles, and the loans, and their value is contractually established
as a percentage of the capital involved.
3
Or SAM-F admits, por simplicity, that all the dividens distributed to families are transfered to them indirectly, througn
the intermedited capital fund.
4
In the case of simultaneous occurrence of payments and receipts of an agent to/from itself, only the net value is
represented in the matrix.

6
7
 The SAM-F also contains lines and columns that represent the accounting of the
agents’ net assets, and show how they convert the result of current account transactions
into changes in the net asset position in the intermediation fund. This represents, in
particular, the financing of the current account deficits of the government and of the rest
of the world by changes in their exposure in the fund.
Table 6 presents the SAM-F for Brazil, in 2003, used in this study.

3 THE CGE-F MODEL

In this section we succinctly describe the CGE model used in this study. It is an
extension of a conventional CGE model to include the representation of the financial
system presented in the previous section. The conventional part of the model
approximately follows the formulation proposed by Robinson, et al. (1999) for a
standard CGE model for public policy analysis, specialized for the structure of our
economy. The financial part is described in the first sub-section below. The complete
set of equations and the list of variables and parameters of the model, including the
conventional and the financial part and the equations that link them, can be found in
Appendix B.5
There are five representative agents: families, non-financial enterprises, financial
enterprises, government and the rest of the world. There are two factors: capital and
labor, and two products, each produced exclusively by the corresponding enterprise: the
real good and financial services. In each sector value added is given by a CES
production function of the factors and, 6 once chosen the level of production, the
demand for intermediate inputs is given by a linear activity system (Leontief).
Production is allocated between domestic sales and exports through a CET technology. 7
The domestic supply is composed, for each product, by a CES aggregation of domestic
goods and imports (the Armington hypothesis). Final demand for this composite good
comes from families, government, and investment. Consumption of families and
government is determined by a linear expenditure system (LES) where the fraction of
disposable income allocated to each good in the basket of the agent is constant.
Savings of the families is the residual part, and is therefore also a constant fraction
of disposable income. Government saving is the fiscal surplus, equal to the difference
between tax revenue and its current expenditure. If it is negative, there is a deficit.
Enterprise savings, both in the financial and non-financial sectors, is the part of profit
which is not distributed, and is a constant fraction of net earnings. The demand for
investments in physical capital of each of the domestic sectors is derived from the
capital required by the respective production function to satisfy the final and
intermediary demand for its product or service.
The interaction between the real and financial sides of our economy has as
fundamental elements the models of the workings of the domestic financial market, and
of the flow of foreign investment, which is the part of the international financial market
the affects the country more. The domestic market is modeled as an intermediation fund
that borrows resources from the agents and lends them to other agents. The model of the

5
The appendix is available under request to the authors.
6
CES means Constant Elasticity of Substitution.
7
CET means Constant Elasticity of Transformation ,.

8
supply of foreign capital can be seen in this context as the model of the financial
decisions of agent rest of the world. They are discussed below.

3.1 THE INTERMEDIATION FUND

This section describes how were represented in the model the operational decisions
of the capital intermediation fund, that reflects the financial decisions of agents. Each
agent’s objective, as it lends or borrows resources from the fund, is to transfer buying
power between the present and the future. This decision depends on its current deficit or
surplus, and of parameters like the rate of return of the investment and the interest rate
on debt, the risk involved in the transaction, the degree of risk aversion of the agent, and
the term of the transaction.
The objective can be formalized as being the agent’s discounted expected utility
maximization, both for enterprises and families, but it is not feasible to include it
explicitly in a CGE because the added dimensions of time and uncertainty render the
solution of the resulting stochastic dynamic general equilibrium model extremely
complex. Alternatively, we model the implications of this behavior for the operational
indicators of financial intermediation.
This is done through a simplified technology that describes simultaneously the
demand and supply of the resources that transit through that market. This means,
therefore, that we built a synthetic technology that describes the aggregate behavior of
the agents, in that market. It is based on the actual performance of this market in Brazil
in the period we consider, and will be formally described below.

3.2 A TECNOLOGIA DO FUNDO

We assume that the intermediation fund is characterized as a technology that accepts
resources as deposits ( Ai ), and distributes them as loans ( Ei ), where the index
i = 1,...,5 represents the institutions considered here (families, non-financial institutions,
financial institutions, government, and rest of the world). It is schematically represented
in Figure 2.
FIGURE 2
SCHEME OF THE OPERATION OF INTERMEDIATION FUND.
BORROWING (CES)

LENDING (CET)

Ai Ei

We assume that the technology in borrowing from different agents is Cob-Douglas

i.e. the elasticity of substitution between funds from them is constant and equal to one,

9
and that the technology in the lending of the funds is CET, i.e. the elasticity of
transformation in placement of the funds is also constant, but not necessarily equal to
one. This specification is suggested by the empirical analysis of the time series of the
shares of the different agents in the fund’s borrowing and lending operations. are
displayed in equation (1).
1/ ρ
5
⎛ 5 ⎞
∏ Ai ≥ X ≥ ⎜ ∑ β i Eiρ ⎟
ϕi
(1)
i =1 ⎝ i =1 ⎠

where ϕi , β i , B are positive constants such that ∑ ϕi = 1 and ∑ β i = 1 , and

5 5
i =1 i =1

ρ > 1 is such that σ = ( ρ − 1)

−1
is the elasticity of transformation in lending. The
variable X is the aggregate input and output of the fund, and represents its volume of
intermediation.
The fund operates competitively, and takes the interest rates for the borrowing and
lending, represented by rA,i e rE ,i respectively, as given, and maximizes profit, which is
equal to the interest revenue from loans extended, less the borrowing costs. Since the
technology in (1) displays constant returns to scale, the maximum profit will be null in
equilibrium.
Profit maximization can be achieved in two stages. In the first, the borrowing
problem is solved, taking the level of operation of the fund as given.
⎧ 5
Minimize
⎪ ( Ai )
⎪
∑
i =1
rA,i Ai
I) ⎨ 5
(2)
⎪Subject to
⎪⎩ ∏i =1
ϕ
Ai i ≥ X

The first order conditions of the restricted optimization in (2) imply the existence
of a Lagrange multiplier λ > 0 such that equations (3) are satisfied:
rA,i Ai = ϕi λ X , i = 1,...,5 (3)
The solution of system of 6 equations composed of the FOC and the production
function yields the fund’s demand for deposits Ai and its minimum cost c( X ) = λX as
a function of rA,i and X . In the second stage the fund maximizes its profit, as indicated
in (4).
⎧ 5
Maximize
⎪⎪ (Ei ), X ∑ =
rE ,i Ei − c( X )
(II) ⎨ i 1 (4)
( )
1/ ρ
⎪Subject to
∑ i=1 βi Ei ≤ X
ρ
5
⎪⎩
The Lagrange multiplier is the same in problems (I) and (II). The FOC of (4) are
given in (5).
ρ −1
⎛E ⎞
rE ,i = λβ i ⎜ i ⎟ , i = 1,...,5 (5)
⎝X⎠
The solution of the system of 6 equations composed of 5 FOC plus the restriction in
(4) yields the optimal level of financial intermediation X ∗ and the optimal level of

10
loans from the fund to each representative agent, Ei∗ . Back substitution of X ∗ into the
FOC (3) yields the optimal borrowing of the fund from each agent: Ai∗ .

3.3 THE AGENT’S EQUILIBRIUM

The last section characterized the partial equilibrium of the intermediation fund,
assuming interest rates are exogenous. However, one needs to consider its general
equilibrium implications: if this is how fund operates, and the agents satisfy their budget
constraints and behave in an optimal manner, what is the vector of interest rates
(rA,i , rE ,i ) that simultaneously equilibrates the financial and the real markets, when the
latter is represented by the equations of a conventional CGE? The answer to this
question characterizes the financial transmission channel.
Savings of each agent is determined in the real side of the economy, and its
accounting is already part of the conventional CGE. It can be invested in real assets or,
if applied in the intermediation fund, it can be transferred to other agents.8 Therefore,
for each agent, the change in the value lent to the fund (ΔAi ) and the change in its debt
with the fund (ΔEi ) have to be made compatible with the savings availability and the
decision with respect to the level of real investment. Therefore, the net asset equilibrium
of each agent requires that the difference between savings and investment, determined
in the real sector, be financed by the net change in the balance of borrowing and loans
of the agent. In the SAM-F (Table 6), this implies that, for the asset accounts, the total
of the values in the lines be equal to the total of values in the corresponding columns, as
indicated in equations (6).
Si + ΔEi = I i + ΔAi i = 1,...,5 (6)
where ΔAi and ΔEi are defined by (7) and (8), where Ai0 e Ei0 represent,
respectively, the net positions of each agent in the fund in the base year.
ΔAi = Ai − Ai0 (7)
ΔEi = Ei − Ei0 (8)
The fund’s total assets and debt must be equal, as indicated in equation (9):
5 5

∑ Ei = ∑ Ai
i =1 i =1
(9)

The budget equilibrium of the agent “rest of the world” determines the supply of
foreign capital. Because it is part of channel of interaction between the real and
financial parts of the economic system, it also receives specialized treatment. That flow
is endogenous, and is determined according to the formulation in Maldonado, Tourinho
e Valli (2007). It is, on average, an increasing function of the rate of change of the
country’s international reserves.
The main empirical hypothesis is the existence of a stable relation between the flow
of foreign capitals (FCAP) and the expected loss of the country’s international reserves
( RLSFRES e ) in “normal” periods, when the balance of payments is not in a crisis
situation, as suggested by Figure 1, and indicated in equation (10).

8
In our formulation the fund can also lend these resources to the agent itself: this constitutes reinvestment.

11
 ⎛ FRES te ⎞
sav Row − LSFRES = FCAPt = f ( RLSFRES te ) = f ⎜⎜1 − ⎟
⎟ (10)
⎝ FRES t −1 ⎠
where FRES is the level of international reserves, and the superscript “e” indicates the
expected value of the corresponding variable.9 The function f is represented in
parametric form adopting a flexible functional form whose inclination, concavity and
limiting derivatives approximate the format of the empirical relation.

3.4 EQUILIBRIUM IN THE ASSET MARKETS

Other relations between real and financial variables can be deduced from the
reinvestment decisions of families and non-financial enterprises. As indicated in (6)
their net earnings are determined in the real side of the CGE model and, added to the net
changes in the exposure in the fund, are either invested in real assets or lent to the fund.
Since the intermediation fund competes with real investments, the rate of interested
it offers to those agents ( rA,i , i = hh, nfin) must be consistent the rate of return of real
assets, represented by R . It is assumed that the equilibrium of the market rates, that
make the agents indifferent between those uses of its capital, is represented by a relation
inspired in Malcomlm (1998) which is similar to the CAPM (Capital Asset Pricing
Model), as indicated in (11).
R = κ i rA,i ( i = hh, nfin) (11)
where κ i represents the increase in return required by agent i to compensate for
accepting the risk of real investments.
It is assumed that the interest rate on loans from foreign capital to the intermediation
fund is determined by the uncovered interest rate parity relation, approximated by the
relation indicated in equation (12).
rA,row = r ∗ ⋅ EXR (12)
where r ∗ represents the foreign interest rate and EXR is the exchange rate.
The credit markets usually limit the indebtedness of private agents to a fraction ηi
of their payment capacity, which is represented here by their savings, as indicated in
(13).
rE ,i Ei = ηi Si ( i = hh, nfin, fin) (13)
An economic interpretation of equation (13) can be given rewriting it as
Ei ≤ ηi ( Si rE ,i ) , and noting that the term in parenthesis is the present value of and
infinite flow of savings Si , but it is used here as a purely empirical relation. Therefore,
the indebtedness rate ηi indicates the fraction of that value which the market is willing
to anticipate to the agent as credit.
Finally, since monetary policy responds to several factors that are outside the scope
of our model, 10 its instrument, the short run interest rate on public debt, is considered
exogenous and is used to produce alternative monetary policy scenarios (equation (14)).

9
Expected value is used here in a broad meaning, no in a strict sense of mathematical expectation.
10
Limits to the evolution of the interest rate on public debt that extrapolate the equilibrium context desctibed in the text
are, for example, the need to control inflation and the stability in the level of activity

12
 rE , gov = rE , gov (14)

3.5 MACROECONOMIC CLOSURE

The specification of equilibrium in the real side of the economy in CGEs requires
that some macroeconomic closure hypothesis be adopted, and these usually imply
exogenously specifying the level of some variables. We opted to fix the flow of foreign
investment and the public investment at their levels in the base year, as indicated in
equations (14) e (15).
I i = I i0 ( i = gov, row) (15)
To conclude this section, we count the number of variables and equations that were
added to the conventional CGE model to introduce the financial markets, and verify that
their quantity is the same, and that the new equilibrium is properly specified. In fact, 28
new variables λ , X , { Ei , Ai , rE ,i , rA,i }i =1 , {I i }i =1 , sav Row and 28 new equations were
5 5

introduced, as indicated in Table 7.

TABLE 7
NUMBER OF NEW EQUATIONS IN THE MODEL WITH FINANCIAL INTERMEDIATION
Equation block number (2) (3) (4) (5) (6) (9) (10) (11) (12) (13) (14) (15) TOTAL
Number of equations in the block 1 5 1 5 5 1 1 2 1 3 1 2 28

4 EXPERIMENTS
The objective of the calibration of the model’s parameters is to make its solution
reproduce the data of the base year and, therefore, the equilibrium of the economy. This
involves the calibration of the conventional part of the CGE-F, which was made using
the data in the SAM-F of Table 6 in the usual manner, described in Robinson et al
(1999) and of the financial part, which is done as described in Appendix A.11
However, it is important to note that it is not sufficient that the basic scenario be a
static equilibrium, but it is also necessary that it also be a dynamic equilibrium with
rational expectations, because in equation (10) the flow of foreign capital depends on
the expected rate of increase of reserves. Since the value of that variable in 2003 is not
the long term equilibrium value, we built the basic scenario is a virtual equilibrium of
the model, were that variable it is set to the value it would have under rational
expectations.
In this section we report on some experiments. The first two show the importance of
the extension proposed here by comparing the response of the model to tariff reductions
that mimic the adhesion of the country to international free trade agreements. The other
three experiments reduce key interest rates to simulate public policy. The first reduces
the short term rate paid by the Government on its debt, the second reduces the rate paid
by non-financial institutions on their debt, and the third reduces the interest rate paid by
foreign institutions on loans extended to them by the domestic capital market. The
results allows us to evaluate the power of the transmission channel between the real and
the financial sectors of the economy.

11
The appendix is available under request to the authors.

13
 The simulation of the implementation of free trade agreements in models that have a
financial sector produces larger economic impacts than in those that do not include that
sector. They are better, because it is believed that they are closer to the real world,
where the dynamic effects of the agreements are more important than their direct effects
on country’s flow of external commerce.
The simulation of changes in the reference interest rates of the financial market
show even more bluntly the usefulness of the extension we propose here, because they
not even can be made in CGEs that do not include a model of the financial
intermediation mechanism.
In a broad sense the effects on the real variables in all simulations are relatively
small, but this is a consequence of the nature of CGE models that, as a rule, assume full
employment of factors, as ours does. However, the impacts are useful to identify their
sign and relative magnitude, when comparing different simulations.
Below we discuss how these simulations were made and their results, which are
presented in Appendix B.12

4.1 TRADE POLICY

In this experiment we simulate parametric “symmetric” trade agreements, where
both the import and export tariffs are reduced in one percentage point.13

MODEL WITHOUT THE FINANCIAL SECTOR

There is a small drop in the real GDP (-0,24%) that, added to the exchange rate
depreciation of 0,94%, imply a reduction of GDP in foreign currency of about 1,2%.
Output in the non-financial and financial sectors drops (-0,11% and -0,03%,
respectively)
The consumption of non-financial goods and of financial services by the families
increases 0,26% e 0,06%, respectively. Government consumption of non-financial
goods increases (0,16%), and of financial services does not change. Aggregate savings
and investment reduce 2%. Non-financial sector exports increase (1,2%), and its imports
decrease (-0,4%). There is a decrease in the Government net income (-0,8%) and an
increase in that of families of 0,08%.
International reserves accumulation is 53% larger than in the base case, and there is
74% larger increase in the foreign capital account balance.

MODEL WITH THE FINANCIAL SECTOR

The drop in real GDP (-0,22%), the 0,82% exchange devaluation and the reduction
in GDP in foreign currency (-1,1%) are all about 10% smaller that in the previous case.
Non-financial sector output also decreases about 10% less (-0,10%), and output of the
financial sector drops (-0,24%), rather than staying constant.
The consumption of non-financial goods by the families increases 0,24%, also about
10% less than in the previous case, while the impact in financial services becomes -
0,6%, inverting the sign and expanding the amplitude. Government consumption of
non-financial goods increases 0,15%, an effect which is 10% smaller than before, while

12
The appendix is available under request to the authors.
13
This simulates the increase in export prices that one could expect would result from the reduction in import tariffs of
the commercial partners of the country.

14
that of financial services is stable, as before. Aggregate savings and investment contract
more than before (-2,56%) indicating a larger (negative) impact on growth when the
existence of the financial market is taken into account. Exports of the non-financial
sector increase (1,1%) and imports reduce (-0,2%), both less than in the previous case,
but consistently with the smaller appreciation of the exchange rate in this case.
The drop observed before in Government income is expanded (-0,86%), and
increase in the income of families (0,07%) are both about 15% larger than in the
previous case.
The foreign reserves accumulation is 93% larger than in the base case, and is almost
double what is observed in the model without the financial sector. The increase in the
foreign capital balance (125%) is almost double what it was in the previous case.
Finally, we note there is a reduction in the total stock of capital intermediated by the
fund (-1,4%), and an increase in its average rate of remuneration of 0,01 p.p. This effect
did not exist in the version of the model without the financial market.

4.2 FINANCIAL POLICY

In this section we report three simulation exercises altering different interest rates:
that paid by Government (SELIC), by non-financial sector enterprises, and by the rest of
the world, on their borrowing from the domestic financial market. We discuss each one
in turn below.

CHANGE IN THE INTEREST RATE PAID BY GOVERNMENT

Here we simulate a reduction of 1 percentage point in the basic interest rate of the
economy, the rate paid by government to borrow in the domestic market, mostly to
evaluate the strength of the monetary transmission channel in our model economy.
The real GDP increases 0,07%, producing an implicit monetary multiplier (slope of
the curve ( y, r ) ) equal to 0,7.14 That is a very robust real effect of monetary policy, and
is absent in a CGE model without the financial market. The exchange rate appreciates
by 0,3%.
There is a reduction in the consumption of families, both of non-financial goods and
of financial services (-0,7% and -4,5% respectively). Aggregate savings and investment
increase 2,9%, indicating a strong effect of the reduction of the basic interest rate on
economic growth. Exports of non-financial goods and of financial services are reduced
(-0,05% and-2,2%, respectively) and the imports increase (0,42% and 5,28%
respectively), consistently with the exchange appreciation. The income of families and
government decreases (-0,7% and -0,23%, respectively).
The accumulation of foreign reserves is reduced, from US$ 8.4 billion to US$ 2.1
billion, an effect which is associated to the reduction in the balance in the foreign capital
account, that goes from US$ 5,35 billion to practically zero.
The reduction in the basic interest rate reverberates in the interest rates charged by
the fund on lending to: families (-0,77 p.p.), non-financial enterprises (-0,14 p.p.) and
financial enterprises (0,17 p.p.). It does not affect the rate for borrowing abroad because
it is exogenous. The fund’s borrowing rates also affected: financial institutions (-0,52
p.p.) and government (1,27 p.p.). These changes in the rates produce variations in the
14
To compare this value with others in the literature it is necessary to recall that the interest rates in our formulation al in
real terms.

15
flow of funds between these agents and the intermediation fund. The financial
institutions borrow and lend more (+2,7% and +2,8%, respectively), and the
government does the opposite ( -2,0% and -5,7%, respectively).

REDUCAO DA TAXA DE JUROS DAS EMPRESAS NÃO FINANCEIRAS

We reduced the interest rate paid by non-financial enterprises in their borrowing, to
simulate the effect of an increase in the level of subsidized loans extended by the public
banks to the private sector. This is an important source of investment financing for
several sectors in the Brazilian economy, especially for housing, industrial investments,
and agriculture.
The real GDP is not affected, and the exchange rate increases 0,2% , indicating a
corresponding devaluation of the domestic currency. Aggregate savings and investment
increase 12,4%, indicating that the drop in private domestic interest rate is a powerful
instrument to stimulate economic growth. The impact in the income of families and
government, however, is negative (-4,4% e -1,3%, respectively). International reserves
accumulation is 73% larger, and the current account surplus doubles.
The total stock of savings in the intermediation fund increases 9%, and the average
interest rate increases 1,9% (0,5 p.p.). The changes in rates charged by the
intermediation fund on lending are as follows: families (-6,47 p.p.), financial enterprises
(0,5 p.p.) and government (-6,25 p.p.), and does not affect the external rate. The fund’s
borrowing rates are also affected: financial institutions (-3,41 p.p.), government (+4,78
p.p.). The other are not affected. The reduction in the lending rate to non-financial
enterprises increases the lending rate to government.
These changes in the rates produce variations in the flow of funds between the fund
and the agents. The financial institutions both lend and borrow 22% more from the
financial market, the government reduces its presence both in lending and borrowing
from the fund (-8,8% e -16,6%, respectively), and the resto of the world increases
substantially its lending to the fund (19,1%) .

VARIAÇÃO NA TAXA DE JUROS DO RESTO DO MUNDO

This last simulation shows the effects of a reduction of 1 p.p. in the interest rate paid
by the rest of the world on borrowing from the intermediation fund, to simulate the
effect of a reduction in the basic interest rate of the American monetary authority, and
determine its impact in the foreign investment in the Brazilian economy.
The impact on the real GDP is negative, but small (-0,03%), because it is
compensated by a devaluation of the domestic currency 0,3%. Aggregate savings and
investment are marginally reduced (-0,13%), and the impact on growth is modest.
Nevertheless, the composition of output tends to change significantly in the medium
term, because the investment by families increases 28%, while that of non-financial
enterprises and government are reduced (-11% and -18%, respectively).
There is a smaller international reserves accumulation (-19%), and a reduction in the
current account surplus of the balance of payments (27%). The impact of the
devaluation on international transactions of the non-financial enterprises is to increase
exports (+0,2%), reduce imports (-0,4%), and increase the commercial surplus.
Overall, the impact is small when compared to the experiments with the other
interest rates.

16
5 CONCLUSIONS
In this paper we showed how a computable general equilibrium (CGE) model of the
Brazilian economy was extended to include an explicit model of financial market. The
model was implemented and calibrated for 2003, and used in some comparative statics
exercises designed to highlight the interactions between the financial and real parts of
the economy.
It is an advance in the applied general equilibrium literature, both in Brazil as well
as abroad, and contributes by not only providing an conceptual and analytical
framework for modeling the financial market and its interaction with real economy, but
also by implementing it completely.
The model was built by adding to a standard CGE model a set of equations that
represents the financial market. They establish linkages between the financial and real
sides of the economy, and describe how different agents act in the financial markets,
and how the equilibrium of the extended model (CGE-F) requires that equilibrium is
simultaneously reached in both markets. This makes this interaction truly bidirectional.
The financial market is modeled as an intermediation fund that borrows from some
agents and lends to others at interest rates that are specific to each agent and the nature
of the operation. The intermediation fund operates a technology that transforms funds
borrowed into funds loaned, and its decisions are made in a competitive manner, taking
rates as given. However, the usual general and partial equilibrium conditions are
superimposed on this context, requiring that budget equilibrium of the agents and of the
fund be respected.
After calibration the model was used to examine some public policies, to illustrate
its usefulness. We compared the solution of the model with and without the financial
market to parametric changes that simulate the adhesion of the country to symmetric
free trade agreements (reduction of 1 p.p. in the import and export tariffs). We also
analyze the impact of parametric shocks to three interest rates: a reduction of 1 p.p. in
the basic interest rate of public bonds, in the interest rate for loans to the no-financial
enterprises, and in the reference foreign interest rate. The results indicate that the
existence of the financial transmission channel in the Brazilian economy alters
significantly the impact of public policy, and that financial effects should be taken into
account when formulating them.
In comparing the simulations of symmetric free trade agreements with and without
the financial system we observe that the majority of impacts on quantities is toned
downs by between 10% and 15%, while the effect on the nominal variables (capital and
income) are expanded. This can be justified intuitively realizing that in the extended
model there is a larger set of prices to absorb the impact of the shock.
In the simulations of interest rate changes we note that a reduction of the basic
interest rate has a significative impact on income (+0,7%), on investment (+2,42). The
reduction in the interest rate for loans to non-financial enterprises does not affect the
output, but has an important impact on savings and investment (+12,4%) and, therefore,
on growth. The reduction of the foreign interest rate has a small impact on the domestic
economy. The repercussion of these exogenous shocks on the other interest rates ando n
the flows of the financial market are complex, and have been discussed in the text.
In conclusion, in this paper we showed how a CGE can be extended to incorporate a
model of the financial market that interacts with the real sector of the economy,
significantly increasing its capacity to represent in the simulation of shock and

17
conventional policies, and extending its utility by permitting the analysis of financial
market policies and shocks.

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