Unemployment and the credibility of exchange rate pegs: evidence from the Brazilian currency crisis of January 1999

The paper examines the vicious circle into which Brazilian authorities found themselves after the outbreak of the Asian crisis as a result of the excessive rigidity of the nominal exchange rate. The vicious circle we focus on implies that worsening exchange rate expectations lead to higher nominal and real interest rates and therefore to higher unemployment. Higher unemployment, in turn, affects expectations negatively. We estimate a three equation model explaining exchange rate expectations (the credibility of the peg), the rate of unemployment and the short term interest rate. The latter equation can be interpreted as a reaction function of the Brazilian monetary authorities.