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Based on the hypothesis that the rules of monetary and fiscal policy in Brazil may
have been subject to different regimes, the present study applies the Leeper model
(1991 and 2005) to identify the chronology of policy regimes in terms of their active
and passive character. The policy rules are estimated using the Markov-switching
model, with a monthly database from November 2002 to December 2015, in which
the regimes are endogenously determined. The results obtained indicate that fiscal
dominance occurred in 2010 and between 2013 and 2014, while monetary dominance
marked much of 2003 and the period 2005–2007. The model also seeks to explain
why the inflation rate continued to rise during 2015 even though Central Bank of
Brazil took an active monetary policy stance that year.
Keywords
Monetary policy, fiscal policy, inflation, gross domestic product, public debt,
macroeconomics, econometric models, Brazil
JEL classification
E31, E52, E62, H60
Authors
Tito Belchior S. Moreira is a Professor in the Department of Economics of the Catholic
University of Brasilia. Email: tito@pos.ucb.br.
Mario Jorge Mendonça is a Planning and Research Technician at the Department of
Macroeconomic Policies and Studies (DIMAC) of the Institute for Applied Economic
Research (IPEA) (Brazil). Email: mario.mendonca@ipea.gov.br.
Adolfo Sachsida is a Planning and Research Technician at the Department of
Macroeconomic Policies and Studies (DIMAC) of the Institute for Applied Economic
Research (IPEA) (Brazil).
Email: sachsida@hotmail.com.
82 CEPAL Review N° 135 • December 2021
Fiscal and monetary policy rules in Brazil: empirical evidence of monetary and fiscal dominance
I. Introduction
The government budget constraint means that the government’s current debt must be compatible
with the present value of its future income. The optimal monetary rule assumes that fiscal policy is not
relevant to monetary policy and public debt is therefore assumed to be sustainable. In other words, the
fiscal authority will always adjust taxes to ensure the payment of the debt. However, if the government
uses seigniorage to balance the budget, the budget deficit will impact on the current or future rise in
the money supply. It therefore needs to be determined whether the rise in debt may lead to an increase
in the rate of inflation.
As remarked by Walsh (2003), if fiscal policy acts independently, the monetary authority is forced
to create seigniorage revenue to balance the government accounts.1 Leeper (1991) describes this
situation —where fiscal policy is active and monetary policy is passive— as fiscal dominance. Sargent
and Wallace (1981) show that one adverse effect of fiscal dominance is that if the primary balance
falls, seigniorage revenue will have to be increased in order to accommodate the government budget
constraint. In this context, attempts to control current inflation will lead to higher inflation in the future.
The idea underlying this point is this: reducing seigniorage revenue will increase the deficit and, thus,
total debt.
Over time, the monetary authority will be forced to increase the money supply.
Leeper (1991) states that equilibrium policies can be classified in two ways, on the basis of a fiscal
policy rule or a monetary policy rule. The first set are those in which the basic rate of interest responds
to the rate of inflation (monetary rule) and taxes respond to fluctuations in public debt (fiscal rule). Here,
monetary policy is active and fiscal policy is passive, fiscal shocks do not influence equilibrium prices,
interest rates or real wages. This first case is a situation of monetary dominance. In the second set of
rules, fiscal policy is active and monetary policy is passive. Fluctuations in public debt lead to money
creation. In this case, the public deficit increase inflation, prices depend on government liabilities and
the nominal interest rate depends on the relation between the amount of money and the government
debt. A monetary contraction will push up inflation.
This second situation is one of fiscal dominance,
where monetary policy is a consequence of fiscal policy.2
Leeper (1991) studied the interaction between monetary and fiscal policy by analysing the
equilibria produced by these monetary and fiscal parameters. In this model, monetary policy defines
the nominal interest rate as a function of current inflation, while the fiscal authority choses a level of
direct taxation in response to the rise in public debt. The parameters of fiscal policy rules determine the
degree of independence of each source of revenue. The parameters associated with an active stance
assume that fiscal policy does not respond to the conditions of constraint that must be applied in order
to maintain equilibrium, i.e. the fiscal authority does not concern itself with public debt sustainability, but
with increasing levels of economic activity, for example. Meanwhile, under the parameters of passive
conduct by the fiscal authority, it would raise taxes when the deficit increases.
Conversely, the parameters of active monetary policy imply that the interest rates controlled by the
central bank respond to the constraints that must be imposed to maintain equilibrium. The parameters
of a passive stance by the monetary authorities would indicate no rise in the base rate when inflation
rises; otherwise, the monetary stance is an active one, i.e. the monetary authority concerns itself mainly
with maintaining price stability and not the level of activity or employment in the economy.
1 Seigniorage revenue comes from two sources. The first is the increase in the real monetary base in relation to revenue. The
second stems from the fact that to keep real cash reserves constant, the private sector needs to increase the volume of the
nominal reserve to a rate roughly equal to the increase in the monetary base.
2 In a seminal work, Martins (1980) established that the prices of securities are equivalent to the price level and that the nominal
interest rate is determined by the ratio between the debt stock and currency reserves.
CEPAL Review N° 135 • December 2021 83
Tito Belchior S. Moreira, Mario Jorge Mendonça and Adolfo Sachsida
Moreira, Souza and Almeida (2007) apply the Leeper model to quarterly data from 1995 to 2006
and find evidence that, in this period, the Brazilian economy underwent a regime of fiscal dominance.
Starting from the hypothesis that policy rules in Brazil may have been subject to different regimes,
this study uses the Leeper model (1991 and 2005) to establish the chronology of the activeness or
passiveness of monetary and fiscal policy rules. Moreira (2009 and 2011) tests empirically whether
Brazilian fiscal policy was active or passive. The empirical results show that the channels of transmission
of fiscal policy are seen through the effects of the public debt to GDP ratio on money demand, the
primary surplus, the nominal interest rate, investment and the output gap. Lastly, estimates based on the
Leeper model show that the Brazilian economy is characterized by fiscal dominance, which describes
the fiscal theory of the price level.
In this context, the contribution of this work is to identify the interaction between fiscal and
monetary policies, on the basis of endogenous Markov regime-switching. In other words, policy rules
or response functions are estimated using the Markov-switching model. The sample comprises monthly
data from 2002 to December 2015. The results obtained support the affirmation that fiscal dominance
occurred in 2010 and between 2013 and 2014. Monetary dominance was present during much of
2003 and in the period 2005–2007. The model also explains why the inflation rate continued to rise
in 2015,
despite the central bank’s adoption of an active monetary policy.
The present article is divided into seven sections, including this introduction. The second section
presents the broad lines of the Leeper model (1991). The third describes the Markov-switching model,
which is used in the fourth and fifth sections to estimate, respectively, the fiscal and monetary response
functions. The sixth section analyses the activeness or passiveness of monetary and fiscal policy rules
in Brazil; the seventh offers concluding remarks.
