This question will walk you through some facts about Brazil's 1998 exchange rate crisis and will ask you to use the concepts seen in class to analyze the reasons why the Brazilian central bank decided to devalue the real (Brazilian currency) in January 1999. Context: In 1994, a stabilization plan (Real Plan) was implemented in Brazil to stop the hyperinflation the country had been experience since the 1980s. As part of the stabilization plan, the Brazilian central bank adopted a fixed exchange rate regime in 1994, with a fixed exchange rate of approximately 1 real per dollar between 1996 and 1998.

a. (10 points) At the exchange rate of 1 real per dollar, the real exchange rate decreased dramatically, which in turn led to increased trade balance deficits. Using the IS-LM-FX diagrams, show how a reduction in the trade balance affects output and interest rates, assuming the peg is credible and the central bank is able to keep the exchange rate fixed. Label the initial equilibrium A and the equilibrium after the change B.

b. (10 points) Between 1994 and 1997, Brazil's government deficit increased by almost 40% due mostly to an increase in government expenditures. Using the IS-LM-FX diagrams, show how an increase in government expenditures affects output and interest rates, assuming the peg is credible and the central bank is able to keep the exchange rate fixed.. Label the initial equilibrium A and the equilibrium after the change B.

c. (6 points) Assume that the effects of trade balance deficits dominate the increase in government expenditures, therefore lowering the equilibrium output. Would this change pressure nominal exchange rates (R$/US$) to appreciate or depreciate? In this case, describe how the central bank could use reserves to bring the exchange rate back to 1 real per dollar

d. (14 points) The 1997 Asian financial crisis and the 1998 Russian crisis made the Brazilian economy susceptible to a series of speculative attacks, followed by a reduction in external credit and foreign reserves. In this scenario, foreign investors no longer considered the peg credible, and demanded a higher interest rate premium. Using the IS-LM-FX diagrams, show the effects of this change in investors' expectation on interest rates, output and exchange rates for 2 cases: 1) if the central bank decides to keep the exchange rates fixed, and it is able to do so; 2) if the central bank allows the exchange rates to float. Draw separate diagrams 1 for cases 1 and 2, and label the initial equilibrium A and the equilibrium after the change B in each case.

e. (10 points) In January 1999, the Brazilian central bank abandoned the peg and allowed the currency to float. However, with the persistence of high interest rate premiums and strict inflation targets, the central bank decided increase interest rates to 19% by the end of 1999, resulting in a small depreciation of the real. Using the IS-LM-FX diagram for case 2 in d, show the effects on output and exchange rates of this conservative policy.