Current Account and Real Effective Exchange Rate Dynamics: The Role of Nonlinear Dynamics in Brazil

Abstract

Current account imbalances significantly impact economic policy, with
sharp exchange rate movements often causing disruptions. Hamilton’s
[1989] Markov Switching Model introduced a framework for analyzing such
dynamics. Few papers have used non-linear multivariate models to study
current accounts and real effective exchange rates. This paper documents
the existence of non-linearity by estimating a Markov Switching VECM
and showing its superiority against a linear benchmark for the Brazilian
economy in the period of inflation target and dirty floating regime. The
monthly frequency and the sample cover the period from 1999-2 to 2024-3.
Two regimes were identified. One regime is related to crisis events and the
other to tranquil periods. Both real exchange rate and current account
dynamics differ across regimes highlighting the necessity of modelling non-
linearity.