Inflation Dynamics in Brazil: The Case of a Small Open Economy

Abstract

This paper derives and estimates a structural model for inflation in an open economy. The model represents the standard new-Keynesian Phillips curve (NKPC) and the hybrid curve proposed by Woodford (2003) and Gal´ı and Gertler (1999) as special cases. We present two sets of estimates for the Brazilian economy, initially regarded as a closed economy and then as a small open economy. According to the recent literature, the model contemplates indexation to past inflation and a measure of marginal cost as relevant inflation indicators. Some of the results can be summarized as follows: (i) Brazil, when regarded as a closed economy, has a relatively higher level of nominal rigidity than that of the United States and Europe, and a high level of indexation as well; (ii) In an open economy with indexation, nominal exchange rate appreciation plus foreign inflation affects consumer inflation, and this effect becomes more intense with larger economic openness; (iii) There is a small direct impact of the variables associated with economic openness, with the sum of their coefficients being close to zero; (iv) However, the indirect impact is significant, consistently changing the weights associated with lagged inflation and the expected future inflation.