Is there a Role for Independent Monetary Policy in Barbados?

Author(s): Tarron Khemraj, Kester Guy and Ashley Bobb

Conventional monetary theory holds that a country can only possess one nominal anchor in the long run. With an open capital account, the country must decide between an exchange rate target or independent monetary policy. The latter implies inflation targeting with a benchmark interest rate reacting to output gap, inflation gap and possibly a macro-prudential variable. This paper addresses this question in the context of Barbados by exploring a novel channel of the transmission mechanism. We argue that shocks to the foreign exchange constraint engender dynamic changes in bank assets, bank liquid assets, aggregate output and price level. Therefore, an examination of the transmission mechanism in small economies requires that the foreign exchange constraint be taken into account. There is tentative evidence that the Treasury bill rate in Barbados could serve as a benchmark reacting to shocks in the foreign exchange market. The Treasury bill rate could help to smooth the flow of foreign exchange through the Barbadian foreign exchange market. Seen in this light, the benchmark rate allows for a dual, but secondary anchor, in support of the primary exchange rate target. Once this interest rate is determined in the primary Treasury bill market, and not in a flexible yield secondary market, the monetary authority can minimize the domestic debt burden associated with the benchmark. Moreover, imperfectly competitive buyers of Treasury bills can purchase in bulk and still make profit at a lower interest rate, thereby reducing the debt burden.