This paper presens a dynamic general equilibrium model to assess the quantitative relation between fluctuations in real interest rates and business cycles in the Brazilian economy. When firms are subject to working capital restrictions, the model is consistent with the cyclical volatilities of national income components as well as with the countercyclical character of real interest rates. Simulations with alternative Taylor rules indicate how econometric estimations of the dynamic IS curve are susceptible to the Lucas critique. The paper suggests how the inflation targeting model currently used by the Central Bank of Brazil should be transformed to incorporate its findings.
