The hope that lower real interest rates and higher growth would follow the floatation of the Brazilian Real was in large measure frustrated. Two international liquidity crises, caused by the reversal of capital flows, occurred in 2001 and 2002. These crises were associated with higher interest rates, lower economic activity, and higher inflation. Therefore, the term “exchange rate stagflation” seems to characterize the essence of this phenomenon. A stylized model by Caballero and Krishnamurthy  explains these events. The main characteristic of the model is that domestic investment depends on the aggregate international liquidity of the economy, which is a limiting factor. During a liquidity crisis, liquidity is reduced, and the economy falls in recession. Neither the fiscal authority nor the monetary authority can reflate the economy by increasing government expenditures or the money supply.
The bulk of the difficulties Brazil faced in 2002 stemmed from the uncertainty associated with the course of the future economic policy to be followed by the new administration and from the sustainability of the public debt. To avert a painful default, real interest rates must fall and sustained growth must resume. To increase the chances of success, several policy measures are suggested: