Endogenous foreign capital flow in a CGE model for Brazil: The role of the foreign reserves

In this paper, we model foreign capital flow to Brazil as stemming from an investment decision whose risk depends on the expected rate of loss of foreign reserves. This motivates the estimation of an empirical relationship between these two variables that is valid for “normal” periods (when there is no foreign exchange crisis) which is used to calculate the capital flow associated with a given expected rate of foreign reserves loss. This empirical relationship is then introduced in a General Equilibrium Model which had been previously implemented for Brazil, but had exogenous foreign capital flow, to produce a version of it with endogenous capital flow. After adjusting the base year to build an artificial base case where the market for reserves is in equilibrium, we compare the response of the two versions of the model by simulating the implementation of the trade agreements with the Americas (ALCA) and with the European Union. The main conclusion is that the inclusion of endogenous foreign capital flow in the model significantly amplifies, and in some cases changes, the real effects of these free trade agreements.