Theoretical and empirical analysis of the Barbados balance of payments situation

Author(s): Crowe, Christopher W F (1999)

Created 22 Jul, 1999
Categories Working Papers
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Maintenance of the fixed exchange rate against the US dollar has been central to Barbados's macroeconomic strategy since the mid 1970s. Whilst there has been a consensus that the fixed exchange rate has been a guarantor of stability and prosperity, its defence has been characterised by periods of painful macroeconomic adjustment, particularly in the early 1980s and 1990s. Interest in the issue of currency crises grew as the Bretton Woods system of fixed pegs broke down in the 1970s and a number of developing countries underwent periods of disequilibrium and adjustment in the 1980s. 'First generation' models of such crises stress the role of domestic credit expansion which runs down reserves and undermines the authorities' attempt to defend the fixed parity. According to these models, speculative behaviour leads to a currency crisis and a breakdown of the fixed parity before reserves are totally depleted, as the private sector anticipates the devaluation and wipes out the remaining reserves to avoid holding a depreciating asset. Later 'second generation' models approach the issue from a political economy perspective, and argue that currency crises are a result of inconsistencies between domestic and external policy objectives generally. These models are less mechanistic than their 'first generation' counterparts, and allow for the existence of multiple equilibria driven by the expectations of their private sector. In this paper a model is presented which modifies the 'first generation' analysis by introducing capital market imperfections in order to model for the effects of exchange controls and other more intrinsic impediments to free capital movements. The model is estimated using monthly data for Barbados over the 1976-98 period. The results indicate that unbridled speculative behaviour would on a number of occasions have dislodged the currency from its US dollar peg. The maintenance of strict exchange controls has thus been central to the continued defence of the Barbados dollar. If, as at present, domestic credit is allowed to grow at a rate inconsistent with balance of payments equilibrium, the retention of exchange controls is to be recommended. The empirical results are also supportive of the generally-held conviction that the present degree of domestic credit expansion is likely to lead to a 'crisis' some time in the not-too-distant future: this paper therefore supports measures to constrain domestic credit growth in order to protect the foreign exchange position. The paper notes the strong complementarities between Barbados's exchange rate policy and incomes policy as mutually reinforcing anti-inflationary strategies. Finally, the continuation of the fixed exchange rate is recommended, as it facilitates the adoption policies aimed at maintaining macroeconomic balance.

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