The goal of this paper is to provide a better understanding of monetary policy effectiveness in the case of indexed bonds. When public debt management deals with bonds indexed to the interest rate set by the monetary policy, there is no wealth effect and, as a consequence, monetary policy has a weak transmission channel reducing its effectiveness. This can help to explain why monetary policy in Brazil has been so tight and interest rates so high during the Real Plan.
Since the implementation of Brazil’s Real Plan in 1994 and the beginning of a period
of stable inflation, the monetary policy of the Brazilian Central Bank has been
qualified as very tight. Not only are interest rates very high, so is their response to
inflation shocks (Minella, Freitas, Goldfajn and Muinhos 2003). This result casts
doubt on monetary policy’s effectiveness to stabilize the inflation rate in Brazil.
Some economists argue that public debt management in Brazil may be
responsible for this weakness and, as a consequence, for the tightness of the
monetary policy. Actually, they argue that the existence of public debt indexedto short run Selic interest rate does not permit that the wealth effect channel of
monetary policy fully operates.1
This paper makes an attempt to quantify the monetary policy transmission
through the wealth effect. The wealth effect is related to how wealth variations
induced by monetary policy affects aggregate demand. The seminal contribution
came from Pigou (1943) who argued that deflation would increase wealth leading
to the expansion of aggregate demand. Modigliani (1943 and 1963) and Ando and
Modigliani (1963) extensively studied how the wealth effect could stabilize labor,
goods and monetary markets delivering its contemporaneous interpretation of the
wealth effect.
In the applied field, the macro econometric models in the 1960’s and 1970’s
predicted significant impacts caused by the wealth channel. Ludvigson, Steindel
and Lettau (2002) conducted an experiment to investigate the role of the wealth
effect in the Data Resources, Incorporated (DRI) model, the Washington University
Macroeconomic Model (WUMM) and the Federal Reserve Bank (FRB) model and
reported large impacts.
Although those macro econometric models pointed out some important effects
of the wealth channel, there is a trend in the recent models to abandon it. This trend
may be explained by the recent research on monetary policy transmission that has
concluded it has a secondary role compared to direct interest rate effects (Boivin,
Kiley and Mishkin 2010).
Fair (2004) also provides evidence of small wealth effects, concluding, however,
that the large capital gains during 1995-2000 were responsible for the great
performance of the U. S economy. In other words, despite the small estimated
coefficients, the wealth effect may have large macroeconomics consequences.
Because of this controversy, the interest in this theme has been renewed in order to
understand the changes that might have occurred during the recent period.2
Other than that, public debt management offers an efficient way for consumption
smoothing over time. On the positive side, public debt can help overcome
imperfections in financial market intermediation (Woodford 1990). Public debt
provides liquid assets in private wealth, thereby increasing the flexibility of theprivate sector in responding to variations in income and spending opportunities.
Furthermore, much of the literature has investigated whether changes in the structure
of debt has macroeconomics implications. For instance, there has been a number
of studies which consider whether debt management will have effects on asset
prices.3
The main goal of this paper is to study how indexed bonds affect the transmission
of monetary policy. For this study, Brazil seems to be a rich laboratory because
public debt management led to an increasing indexation of bonds to short term
interest rate – Selic. In the next section, this debate and the main implications of
public debt management for monetary policy are presented. In the third section, a
counterfactual experiment, following Boivin and Giannoni (2002) is performed to
assess the role of public debt indexation in the monetary transmission process. A
structural VAR is estimated to provide wealth and public debt management effects
on consumption. Counterfactual exercises are implemented in order to assess the
whole role of indexation on monetary policy transmission. The results indicate that
indexed bonds to Selic interest rate weakened the effectiveness of monetary policy
in Brazil.
The purpose of this paper is to provide a better understanding of the channels through
which monetary policy in Brazil influences real variables. The high level of the
short term interest rate in Brazil and a strong monetary policy reaction function
have been taken as puzzling facts since the adoption of the Real Plan which brought
inflation down. In order to provide an explanation (or one explanation more) we
quantified the Brazilian Central Bank policy impact on consumption through the
wealth effect.
Our results indicate that the wealth effect may be a relevant channel of monetary
policy transmission in Brazil. Nevertheless, the econometric experiments indicate
that the share of indexed bonds makes the wealth effect non-significant. In other
words, the high share of indexed bonds compromises the wealth effect on consumption,
consequently the monetary transmission mechanism through wealth and as a result
reduces the power of monetary policy. Summarizing, the data suggest that there is
a negative wealth effect on consumption induced by a rise in the interest rate.
However it is offset by the presence of bonds indexed to the interest rate.
