Introduction

In Barbados the main policy anchor is the exchange rate. Pegged at $1 BBD to $2 USD, it maintains parity with the US and other USD-pegged economies. In order to maintain the peg, the Central Bank of Barbados may need to intervene in the market when upward or downward pressure is put on the market exchange rate. To do so, the Central Bank of Barbados needs to hold foreign reserves. The evolution of the policy anchor means that the main aim of economic policy in Barbados is maintaining adequate foreign reserves.

The existing framework for maintaining foreign reserves is based on fiscal adjustment. This policy framework is outlined in Worrell (2016?). Reduce domestic demand by reducing the income of Barbadians, and they will reduce imports. This should stem the outflow of foreign reserves in the short run. Worrell assumes that in the short run, policies affecting inflows (supply of foreign reserves) cannot be altered.

While the Central Bank is the authority charged with maintaining the fixed exchange rate, they play no role in this policy framework. The argument goes that the monetary authority is bound by the international trilemma—it cannot have a fixed exchange rate, an open capital account, and independent monetary policy.

But Barbados does not have an open capital account. In fact, according to the Chinn-Ito Index for 2016 based on restrictions on cross-border financial transactions reported in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER), Barbados is at 104th on the list of most open economies (of 182 countries). On a de facto basis,  Barbados ranks similarly. The country has a foreign direct inflows to GDP ratio of 286% on average from 1974 to 2017. It ranks 92nd in the world out of 243 countries. However, much of this foreign investment flows into the offshore business sector, which does not affect real domestic economic variables. The international trilemma does not bind.

What can Barbados do with its monetary policy to combat foreign reserve declines in the short run? Can monetary policy do a better job than fiscal policy? This paper tries to answer these questions.

To do so, we’ll use a simple dynamic model of consumption. Households consume domestic and imported goods. The greater the demand for imported goods, the lower the foreign reserves will be. The aim, then, is to determine how monetary policy can lower outflows of foreign reserves.

In an economy with a closed capital account, we focus on a single main channel. Raising the interest rate increases the incentive to save, while reducing the incentive to consume. 

There are two main channels. The first is the savings channel. Raising the interest rate increases the incentive to save and reduces the incentive to consume. The second is the portfolio rebalancing effect. Independent monetary policy allows the domestic interest rate to deviate from the international interest rate. Raising the domestic interest rate can rebalance domestic savings from international investing to domestic investment.

Foreign exchange reserves act as a buffer to reduce the effects of balance of payment shocks, stops to  the economy and negative trade (Bussiere, Cheng, Chinn, Lisack 2014). Rodrick 2006 described economies with high liquid foreign assets as being equipped to resist panics in financial markets and sudden reduction in capital flows. Most literature describes foreign exchange reserves more as an ‘insurance’ mechanism.

Since the Barbadian economy is import driven, reserves play a larger role in Barbados’ day to day economic transactions. Worrell (2012) argued that the balance of external payments and receipts (Net Exports?) of open Caribbean economies is the best way of measuring the stability of these countries. From 2000 to 2010 Barbados has not had a positive current balance. Meaning the surplus aggregate demand should have been financed through foreign exchange reserves(Worrell 2012). So, what explains the reserve growth over the years(see tables below)? Also, what is the cause of the large draining of reserves for the given periods?