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1. Brazil was facing hyperinflation i.e. supply of money was way beyond the demand for the money. Therefore Cardoso designed a real plan to drive out inflation form Brazil. His plan was based on the pegged exchange system. Under this system a country will peg the value of its currency to that of a major currency. The value of the real was pegged to that of the U.S. dollar and allowed to depreciate against the dollar by no more than 7.5% per year. To keep depreciation under control Brazil raised the interest rates repeatedly to maintain the value of the real against the dollar. The high cost of credit helped reduce the expansion of the money supply and brought inflation under control.
. Following steps were taken by the Brazilian government to defend the peg of the real against the U.S. dollar.
„³The Brazilian central bank began to purchase reals in the open markets using its foreign exchange reserves.
„³The government announced $10.8 billion in budget cuts.
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„³ In order to increase the attractiveness of holding the real, the Brazilian government raised the interest rates to as high as %.
. Though the costs of pegging of the real against the dollar were quite high the policy did help the Brazilian government to drive inflation out of the Brazilian economy.
The costs were as follows
„³ Fall in the foreign exchange reserves because f the sale of the real by the central bank
„³ In spite of the budget cuts of approximately $10.8 million dollars traders continued to sell the real.
„³ Hike in the interest rates led to an increase in the cost of servicing the government debts, reducing the government tax receipts and increase in the deterioration of the fiscal deficit.
The benefits were defeat of decades of hyperinflation and stability in the Brazilian economy.
4. Under a floating exchange rate system Brazil would have been able to correct its trade deficit. The imbalance between the supply and demand of Brazil¡¦s currency in the foreign exchange market would have led to depreciation of its exchange rate. In turn, by making its exports cheaper and its imports more expensive, exchange rate depreciation could have corrected the trade deficit. On the other hand floating exchange rate system can lead to speculation of the country¡¦s currency. It can damage a country¡¦s economy by distorting export and import prices. Floating exchange rates would have implied a risky foreign investment in Brazil. This uncertainty would have dampened the growth of international trade and investment.
5. There would have been a major trade deficit in Latin America because imports would be higher than the exports. Floating exchange rate system would also make business planning extremely difficult. U.S. would think twice before investing in Latin America As result the Brazilian economy would be badly hit because Latin America absorbed 0% of all exports from the United States.
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