Emerging economies that have adopted inflation targeting and that combine low credibility, high public debt, and a high interest rate suffer from a typical problem. Increases in the interest rate to reduce departures of inflation from the target imply that a higher primary surplus is required for stabilizing public debt/GDP ratio. This tricky situation is known as “unpleasant fiscal arithmetic” (UFA). This article develops a theoretical model showing how increased financial openness and capital account liberalization can mitigate UFA. Furthermore, empirical evidence from the Brazilian case through OLS, GMM, and GMM system methods is offered. The findings show that increases in capital mobility and financial openness work as a commitment technology, which contributes to the success of the inflation targeting and thus reduces the risk of UFA.

Since the company declared bankruptcy in June 2009, shares of General Motors stock (now known as Motors Liquidation Company) have continued to trade at a high volume while maintaining a market capitalization near $300 million through most of 2010. Anecdotal evidence strongly suggests that both rational speculators and uninformed investors (often mistaking Motors Liquidation for the new, reorganized GM) have purchased the stock. We develop a theoretical asset-pricing model that includes both types of agents. We present two major results. First, the most frequent state is one where a small fraction of rational agents ensure that the share price behaves as if all agents are rational. A second state exists where all rational agents exit and the share price is inflated. Second, fitting the model to Motors Liquidation, we find evidence of irrational asset pricing for this firm. We find little evidence of similar behavior in the share prices of the thirty stocks that compose the Dow Jones Industrial Average.