We develop and estimate a DSGE model for the Brazilian economy as part of the macroeconomic modeling framework of the Central Bank of Brazil. The model combines the building blocks of standard DSGE models (e.g., price and wage rigidities and adjustment costs) with the following features that better describe the Brazilian economy: (i) a fiscal authority pursuing an explicit target for the primary surplus; (ii) administered or regulated prices as part of the consumer price index; (iii) external finance for imports, which amplifies the effects of changes in external financial conditions on the economy; and (iv) imported goods used in the production of intermediate goods. It also includes the presence of financially constrained households. We estimate the model with Bayesian techniques, using data since 1999, when inflation targeting was implemented in Brazil. Evaluation based on impulse response functions, moment conditions, variance error decomposition, and initial forecasting exercises suggests that the model can be a useful tool for policy analysis and forecasting. visit to the Central Bank of Chile, to which we are very grateful. We are also grateful to Tomiê Sugahara and José R. da Costa e Silva for their participation in early stages of the project, and Angelo Fasolo for his comments and suggestions.

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Bank interest spreads, defined as the difference between lending and deposit rates, average about 30 percentage points in Brazil. This figure is ten times larger than the average in industrial countries and three times larger than the Latin American average. This paper analyzes the causes and macroeconomic consequences of these extraordinarily high spreads. Regarding the causes, I argue that the high spreads can largely be accounted for by a credit program that requires banks to allocate a significant portion of their loans to selected high-risk, high-cost borrowers at below-market interest rates. Banks offset their losses in the selected market by charging a disproportionately higher spread in the nonselected market. I construct a general equilibrium model tailored to evaluate the positive and normative consequences of this policy on the Brazilian economy. I find that the pure cross-subsidy between bank borrowers accounts for about a half of the spread levels. I also find that eliminating this policy distortion would raise GDP by 8 percent and almost double the bank credit in the long-run.JEL Codes: E44, G21, O16.

This paper offers additional insights on the relationship between interest rates and business cycles in Brazil. First, I document that Brazilian interest rates are very volatile, counter-cyclical and positively correlated with net exports, as observed in other emerging market economies. Next, I present a dynamic stochastic general equilibrium model in which firms face working capital constraints and labor supply is independent of consumption. This parsimonious model, appropriately calibrated to the Brazilian economy, predicts that interest rate shocks can explain about one third of output fluctuations and delivers business cycle regularities consistent with the Brazilian data.

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