Monetary and fiscal policies coordination underfederalism

Abstract

The purpose ofthis paper is to show that, given its characteristics, the Brazilian federalism implies increasing debts at state level, undermining the central government ability to pursue macroeconomic stability. A simple model is developed to show that under certain conditions, decentralized policy making generates higher aggregate debt and inflation than under coordination at the federal government level. It is also shown that this aggregate debt is an increasing function of the degree of expected future monetization. In order to verify the solvency condition of state governments, a test that evaluates the generating process of the stock of states' debts is implemented. It was found that for the states of Sao Paulo, Rio de Janeiro, and Rio Grande do Sul the time paths of the debts are unsustainable. Brazilian federalism does not enhance long run macroeconomic stability, and a major reform that promotes a wide and clear separation of monetary and fiscal policies is yet to come. Privatizing government financial institutions, limiting states' debts and deficits, and increasing the Central Bank s independence should altogether be considered important institutional changes to promote sound macroeconomic management in Brazil.