The Effectiveness of Monetary Policy in Small Open Economies: An

WP/16/189

The Effectiveness of Monetary Policy in Small Open

Economies: An Empirical Investigation

By Keyra Primus

IMF Working Paper

Middle East and Central Asia Department

The Effectiveness of Monetary Policy in Small Open Economies: An Empirical

Investigation

Prepared by Keyra Primus



Authorized for distribution by Mark Horton

September 2016

Abstract

This paper examines the relative effectiveness of the use of indirect and direct monetary

policy instruments in Barbados, Jamaica and Trinidad and Tobago, by estimating a

restricted Vector Autoregressive model with Exogenous Variables (VARX). The study

assumes that the central bank conducts monetary policy using a Taylor-type rule and it

evaluates the effects of a reserve requirement policy. The results show that although a

positive shock to the policy interest rate has a direct effect on commercial banks' interest

rates, there is a weak transmission to the real variables. Furthermore, an increase in the

required reserve ratio is successful in reducing private sector credit and excess reserves,

while at the same time alleviating pressures on the exchange rate. The findings therefore

indicate that central banks in small open economies should consider using reserve

requirements as a complement to interest rate policy, to achieve their macroeconomic

objectives.

JEL Classification Numbers: E43, E52, E58

Keywords: Reserve Requirements, Macroeconometric Model, Small Open Economies

Author’s E-Mail Address: [email protected]



I am grateful for very helpful discussions and comments from Pierre-Richard Agénor, Winston Moore, Mark

Horton, Tarron Khemraj, Issouf Samake, Reshma Mahabir, Franka Primus, DeLisle Worrell, Darrin Downes

and Trevor Robert.

IMF Working Papers describe research in progress by the author(s) and are published to

elicit comments and to encourage debate. The views expressed in IMF Working Papers are

those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board,

or IMF management.

Contents

I. Introduction ……………………………………………………………........... 3

II. The Caribbean Context …………………….…………………………........... 5

III. Econometric Methodology ………………………………………………....... 7

A. The Standard VARX Model ..…………………………………………....... 8

B. A VARX for Barbados, Jamaica and Trinidad and Tobago ..………........... 8

B.1. Fully Interactive Variables …...…………………………..………......... 8

B.2. Partially Interactive Variables ……….………………..………........... 9

B.3. Strictly Exogenous Variables .……………….…………………......... 11

B.4. Relationship of Variables …...……………….…………………......... 11

IV. Econometric Results ……………………………………………………........ 13

A. Shock to the Policy Rate ………………………………………………….. 13

A.1. Barbados …………………………………………………….............. 14

A.2. Jamaica ……………………………………………………................ 15

A.3. Trinidad and Tobago ……………………………………………....... 16

B. Shock to the Reserve Requirement Ratio ….………………………........... 18

B.1. Barbados ………………………………………………….................. 18

B.2. Jamaica ………………………………………………….................... 19

B.3. Trinidad and Tobago ……………………………………………....... 20

V. Conclusion and Policy Implications …………………………………............ 21

References ……………………………………………………………......................... 23

Table 1. Unit Root and Seasonality Tests ……….……………………………………….. 26

List of Figures

1 Barbados: Shock to the Policy Interest Rate, IRFs ……….……………………….…. 27

2 Barbados: Shock to the Policy Interest Rate, VDs .…...………………………….….. 28

3 Barbados: Shock to the Reserve Requirement Ratio, IRFs ………..…………….…... 29

4 Barbados: Shock to the Reserve Requirement Ratio, VDs ………….……………..… 30

5 Jamaica: Shock to the Policy Interest Rate, IRFs ………………………………......... 31

6 Jamaica: Shock to the Policy Interest Rate, VDs ………………………….……..….. 32

7 Jamaica: Shock to the Reserve Requirement Ratio, IRFs ……………….……….….. 33

8 Jamaica: Shock to the Reserve Requirement Ratio, VDs …………………….….….. 34

9 Trinidad and Tobago: Shock to the Policy Interest Rate, IRFs …………….….….…. 35

10 Trinidad and Tobago: Shock to the Policy Interest Rate, VDs ………………...……. 36

11 Trinidad and Tobago: Shock to the Reserve Requirement Ratio, IRFs …..….....…… 37

12 Trinidad and Tobago: Shock to the Reserve Requirement Ratio, VDs ………….…... 38

I. Introduction

Monetary policy is a key element of macroeconomic management and its e¤ectiveness is an

important issue in economic policy analysis. To successfully conduct monetary policy, policy-

makers must have an accurate assessment of the e¤ects of their policies on the economy. A

crucial element that can determine how monetary conditions can in‡uence the economic perfor-

mance of a country is the choice of the policy instrument used. In developed countries, which

have more sophisticated …nancial systems, there is a general consensus on the use of indirect

instruments— particularly a short-term interest rate— to e¤ect monetary policy. Indeed, wide-

spread empirical evidence has shown that in those countries, the short-term interest rate is

an e¤ective tool for controlling in‡ation and in‡uencing output growth. By contrast, in de-

veloping countries, the monetary authorities typically operate two main policy instruments to

achieve desirable macroeconomic objectives— a short-term policy interest rate and the required

reserve ratio.

However, since early 2000s central banks in those countries have gradually de-

emphasized reserve requirements in favour of a market-based style of monetary policy which

have focussed more on controlling a short-term interest rate. This decision has gained tremen-

dous favour b ecause previous research has shown that the interest rate channel is particularly

important in the transmission mechanism of monetary policy in developing countries.

In small open developing economies, the transmission of monetary policy operates di¤erently

because of weak institutional frameworks and shallow …nancial markets (Davoodi et al. (2013)).

In addition, those countries typically face macroeconomic challenges related to imperfections

in the …nancial sector. For instance, in Caribbean countries, credit market imperfections are

prevalent because the limited competition among banks has led to oligopolistic pricing prac-

tices

and market segmentation. Also, in most of those countries, the banking system has high

persistent liquidity which has hindered the e¤ective transmission of monetary policy to key

macroeconomic variables.

In light of the presence of structural impediments, the key issue is

whether the monetary authorities in those countries should rely solely (or mainly) on indirect

instruments to conduct monetary policy. Previous research has shown that in countries with

structural excess liquidity and credit market imperfections, the short-term interest rate is lim-

ited in e¤ecting monetary policy. At the same time, there has been contrasting views on the

It has been observed that rese rve requirements are generally higher in developing countries, when compared

to developed countries. Therefore, less attention is paid to the use of the required reserve ratio as a policy tool

in developed countries.

It should also be noted that in an interconnected world, small open economies are exposed to developments

in the global economy that can hinder the e¤ective transmission of monetary policy.

The commercial banks in Barbados, Jamaica and Trinidad and Tobago operate under an oligopoly market

structure. See, for instance, Khemraj (2007b) for futher discussions.

Several researchers have examined the issue of excess bank liquidity in various Caribbean countries. See

Maynard and Moore (2005), Khemraj (2007a, 2009), Anderson-Reid (2011), Jordan et al. (2012), Primus

(forthcoming) and Primus et al. (2014).

e¤ectiveness of the required reserve ratio in transmitting monetary impulses to key macroeco-

nomic variables. Nonetheless, because changes in reserve requirements have a direct in‡uence

on liquidity conditions, central banks in many developing countries have had to resort to this

instrument in recent years. For example, between 2008 and 2010, the central banks of Ja-

maica and Trinidad and Tobago increased the required reserve ratio to absorb excess liquidity

and e¤ect monetary policy. This therefore shows that indirect policy instruments should be

complemented with direct policy to ols in order to achieve desired macroeconomic objectives.

To analyze the e¤ect of monetary policy in the Caribbean, several researchers have held for-

mal discussions on the monetary transmission mechanism in Barbados (see Baksh and Craig-

well (1997) and Moore and Williams (2008)), Jamaica (see Robinson and Robinson (1997)

and Urquhart (2006)), and Trinidad and Tobago (see Watson (1996, 2003), Ramlogan (2007),

Cheong and Boodoo (2008), and International Monetary Fund (2011)). These studies fo cus

on evaluating whether money, credit or the exchange rate is the principal conduit of mone-

tary policy impulses, and the strength of these channels in the transmission process. Although

it is crucial to determine the importance of various channels in transmitting impulses from

the …nancial sector to the real sector, the critical issues are which monetary policy tools are

more e¤ective in facilitating such transmission, and how di¤erent policy instruments a¤ect key

macroeconomic variables.

This paper therefore closes the gap in the literature by estimating a macroeconometric model

to evaluate the relative e¤ectiveness of the use of indirect and direct tools of monetary policy

in three of the largest English speaking Caribbean countries— Barbados, Jamaica and Trinidad

and Tobago. In all three countries, the …nancial system has been plagued with structural excess

reserves and the …nancial market is underdeveloped.

See for instance, Ramlogan (2004, 2007),

Holden and Howell (2009), and Birchwood (2011), who also noted that the …nancial market in

the Caribbean is underdeveloped. In light of these characteristics, it is important to investigate

how a market-based style of monetary policy would a¤ect key macroeconomic variables in the

short-run. This is an important issue because the monetary authorities in those countries have

shifted their policy stance to rely more on indirect policy tools (so they adjust the short-term

interest rates frequently) to e¤ect monetary policy. Notably, this research represents an essential

contribution as there has been no previous attempt to assess the e¤ects of di¤erent types of

policy instruments in those countries.

To conduct the analysis, a restricted Vector Autoregressive model with Exogenous Variables

(VARX) is used to provide empirical evidence on the relative e¤ects of interest rate and reserve

In most Caribbean countries, the …nancial sector can be considered “developed”if the indicator used is the

ratio of …nancial assets to GDP. However, …nancial development considers …nancial institutions and …nancial

markets, the latter of which is underdevelop ed in the Caribbean. In a recent study, the International Monetary

Fund (2015) used a broad-based index to measure …nancial sector development. In their study, …nancial sector

development was subdivided into …nancial institutions and …nancial markets. The index showed that in general,

…nancial markets are underdeveloped in the Caribbean.

requirement policy shocks. In the experiments, the policy interest rate is speci…ed in the form

of a conventional Taylor-type rule, whereas the reserve ratio depends only on its past value.

The model considers the essence of the economies in the Caribbean as it includes variables

that capture the dynamic interaction of the real, banking and external sectors, as well as the

monetary and …scal authorities. The extent of the impact of the two policy instruments is

captured through impulse response functions and variance decompositions. The results show

that there is a weak transmission of an increase in the short-term interest rate to output growth

in Jamaica and Trinidad and Tobago. Also, in all three countries, a rise in the policy interest

rate is not successful in reducing in‡ation, implying therefore that indirect policy tools may not

be e¤ective for price stability. Moreover, when the required reserve ratio is used as the policy

instrument, a contractionary monetary policy shock helps to alleviate pressure on the exchange

rate in Barbados and Trinidad and Tobago, and is successful in reducing credit demand in

Jamaica and Trinidad and Tobago.

The rest of this paper is organized as follows. Section II provides some background informa-

tion on monetary policy in Barbados, Jamaica and Trinidad and Tobago. Section III presents

the model and Section IV discusses the econometric results from the impulse response func-

tions and variance decompositions. The …nal section provides some concluding remarks and

suggestions.

II. The Caribbean Context

The objectives of monetary policy in the Caribbean are centred on price stability, ensuring

stability of the exchange rate, maintaining an adequate level of foreign exchange reserves and

…nancial system stability. The monetary authorities are faced with challenges to achieve these

objectives because the open nature of these countries make them susceptible to external shocks.

Also, primarily because of the small size— as well as the distorted …nancial systems to a lesser

extent— domestic and external shocks that a¤ect these economies tend to be magni…ed. There-

fore, in formulating monetary policy, the central banks in those economies must take into con-

sideration prevailing and prospective developments in the macro economy, as well as emerging

external sector developments.

The economies of Barbados, Jamaica and Trinidad and Tobago have similar …nancial struc-

tures. In each country, the commercial banking sector is the largest segment of the …nancial

market, as it accounts for the majority of the …nancial system assets. This sector is dominated

by a few commercial banks and they operate under an oligopoly market structure. Moreover,

there are some di¤erences in the exchange rate policy pursued by the monetary authorities in

These shocks can arise from ‡uctuations in energy prices, spikes in food prices, natural disasters, and capital

account shocks.

those countries. Barbados has maintained one of the longest …xed exchange rate regimes since

the 1980s (Worrell et al. (2003)). By contrast, Jamaica has a ‡oating exchange rate regime, and

Trinidad and Tobago has a managed ‡oat. Quite often, in these economies, extensive central

bank intervention in foreign exchange markets is needed to smooth volatility and protect the

value of the currency.

There are two key factors of the …nancial system that imp ede the transmission of monetary

policy. First, capital markets in each country are at an embryonic stage. Thus, although the

…nancial sector of the three countries improved over the last two decades, the …nancial market

remains underdeveloped. Second, managing excess bank liquidity in a small open economy with

a fragmented market is a key issue for many central banks in the Caribbean. High persistent

excess liquidity has been a permanent feature of the banking system in Barbados, Jamaica and

Trinidad and Tobago; and over the last decade, the level of excess liquidity has risen to record

levels. In Barbados, Maynard and Moore (2005) noted that the macroeconomic environment,

interest rate policy and money creation by the government are the main factors that contributed

to the build-up of excess reserves. Anderson-Reid (2011) found that in Jamaica an increase

government spending— which is facilitated by money creation or borrowing— is associated with

an increase in bank deposits and excess reserves. In the case of Trinidad and Tobago, the

main source of excess liquidity in the economy is the monetization of government deposits

at the Central Bank— which represent tax payments from energy sector companies. Thus, a

signi…cant component of such liquidity has been "involuntary" (see Primus et al. (2014)). In

light of these two issues, the policymakers in those countries have been using a number of

strategies to a¤ect monetary policy.

Several monetary policy tools have been used by the respective central banks. In Barbados,

the monetary policy instruments used are the required reserve ratio, the discount rate, Open

Market Operations (OMOs), moral suasion, and the Central Bank’s policy rate which is the

minimum deposit rate. In 2013, the Central Bank of Barbados initiated a shift in policy

whereby the Treasury bill rate was used as the key tool to in‡uence interest rates in the

banking sector (see Central Bank of Barbados (2013)). Further, in 2015, the Bank ceased

stipulating a minimum rate of interest on savings deposits at commercial banks. In so doing,

the Central Bank’s activity in the …nancial market, which will in‡uence the Treasury bill rate,

will provide guidance for other interest rates in the banking sector. This therefore shows greater

commitment to indirect policy instruments to conduct monetary policy. To a lesser extent, the

Central Bank of Barbados also stipulates reserve requirements on local deposits, foreign deposits

and government securities, in order to in‡uence economic policy.

In the case of Jamaica, the two main operational tools are OMOs and reserve requirements.

The Bank of Jamaica sets an open market interest rate on OMOs to guide market interest rates.

The reserve ratio includes a cash reserve requirement on local currency liabilities and a liquid

assets ratio, which stipulates the percentage of deposit liabilities to be held as risk-free assets

in the form of Government of Jamaica securities of maturities of up to one year (Lattie (2000)).

In addition, for the cash reserve ratio and the liquid assets ratio, a requirement is speci…ed for

foreign currency liabilities.

The Central Bank of Trinidad and Tobago uses a short-term interest rate, OMOs and reserve

requirements to e¤ect monetary policy. OMOs were introduced in 1996 and from 1998 the Bank

started de-emphasizing reserve requirements, while increasing recourse to OMOs (Central Bank

of Trinidad and Tobago (2004)). In 2002, the Central Bank o¢ cially changed its stance of

monetary p olicy towards a more market-based monetary policy style as the ‘repo’policy rate

was introduced as the principal instrument to e¤ect monetary policy (Central Bank of Trinidad

and Tobago (2005)). The Central Bank speci…es a primary reserve requirement and a secondary

reserve requirement as a percent of commercial banks prescribed liabilities.

Unlike Barbados

and Jamaica, commercial banks in Trinidad and Tobago are not subject to reserve requirements

on government securities and foreign currency liabilities.

The above discussion highlights the fact that both the central banks of Barbados and

Trinidad and Tobago have changed their monetary policy regime to rely more on indirect

policy tools to e¤ect monetary policy. The Bank of Jamaica has not explicitly indicated greater

reliance on the open market rate to e¤ect monetary policy. However, an inspection of the data

shows that the Bank mainly manipulates this rate to indicate its stance. Also, with the excep-

tion of the period 2008-2010, the required reserve ratio in Jamaica has been decreasing since

the late 1990s.

Moreover, it has been observed that against the backdrop of high …nancial

system liquidity, changes in the short-term interest rate have not been e¤ective in in‡uencing

real variables and bank liquidity; as a result, the central banks had to use other measures.

This therefore underscores the importance of empirically evaluating the e¤ectiveness of the

short-term interest rate (the key indirect policy tool), in comparison to the reserve requirement

ratio (the main direct policy instrument) to determine how each instrument can help to guide

monetary policy in these three small open economies.

III. Econometric Methodology

This section uses the VARX methodology to examine the transmission of a contractionary

monetary policy shock using the short-term interest rate and the required reserve ratio in

Barbados, Jamaica and Trinidad and Tobago.

Prescribed liabilities represe nt total demand, savings and time deposits, short-term credit instruments with

a maturity up to and including one year and all fund raising instruments maturing within or beyond one year

of the reporting date.

For instance, the cash reserve ratio and the liquid asset ratio of commercial banks on local currency deposits

were reduced from 21 percent and 43 percent, respectively in 1998, to 12 percent and 26 percent, respectively

in 2014.

A. The Standard VARX Model

According to Lütkepohl et al. (2006), the structural form of the VARX model can be written

as,

= A

t1

+ ::: + A

tp

+ B

+ ::: + B

tq

+ C:D

+ u

; (1)

where y

= [y

; :::; y

]

is a vector of K observable endogenous (fully and partially interactive)

variables, x

= [x

; :::; x

]

is a vector of M observable exogenous variables, D

contains all

deterministic variables, which includes a constant, a linear trend and seasonal dummy vari-

ables, and u

= [u

; :::; u

]

is a K-dimensional unobservable zero mean white noise process

with positive de…nite covariance matrix. The A; B and C are parameter matrices of suitable

dimension.

In the VARX framework, restrictions are imp osed in the interactions between variables on

the basis of a priori economic reasoning. Therefore, the VARX system allows for asymmetries

between variables so the number of parameters to be estimated is reduced. This helps to

increase the number of degrees of freedom, as well as improve the e¢ ciency of those parameters

to be estimated. Furthermore, the VARX speci…cation allows the modeler to calculate impulse

response functions and variance decompositions associated with innovations on those variables

that are partially endogenous.

B. A VARX for Barbados, Jamaica and Trinidad and Tobago

Consider a VARX model which contains three blocks of variables:

 a block of fully interactive endogenous variables, the parameters of which are not subject

to restrictions;

 a block of partially interactive endogenous variables, the parameters of which are subject

to restrictions; and

 a block of strictly exogenous variables.

B.1. Fully Interactive Variables

This block consists of two variables:

The …rst variable is the growth rate of real GDP, output_growth

, which is used as an

indicator of changes in aggregate demand and economic activity. This variable is measured by

the change in the logarithm of real GDP. Because GDP data are not available on a monthly

basis, the Lisman-Sandee pro cedure is used to generate a monthly series from the quarterly

series for all countries. This exercise is carried out using the ECOTRIM software.

As the

quarterly data for Trinidad and Tobago is in the form of an index, the data for Barbados and

Jamaica were also converted into an index before the series were interpolated;

The second variable is the in‡ation rate, infl

, which is measured as the year-on-year per-

centage change in the logarithm of the Consumer Price Index (CPI), or Retail Price Index

(RPI) for Trinidad and Tobago.

This variable is a target of monetary policy.

B.2. Partially Interactive Variables

This block consists of nine variables:

The …rst variable is the monetary policy instrument. In the baseline case, a short-term

interest rate, policy_rate

, is used to represent the indirect instrument. The policy interest

rate is the minimum savings rate for Barbados, the OMOs 30 day open market interest rate

for Jamaica, and the ‘repo’rate for Trinidad and Tobago. In the macroeconometric model, the

central bank sets a short-term interest rate using a Taylor-type rule in which the policy rate

depends on the in‡ation rate, output growth, and its past value.

In the next experiment, the

reserve requirement ratio, rrr

, is used to represent the direct instrument of monetary policy.

Thus, this experiment considers a systematic increase in the required reserve rate, which reacts

directly to its past value. This variable is measured using the minimum required reserve ratio on

domestic currency deposits for all countries except Barbados. Over the period of the study the

reserve requirement rate for Jamaica and Trinidad and Tobago was adjusted several times. The

required reserve ratio was last changed in 2010 in Jamaica (from 14 percent to 12 percent) and

in 2008 in Trinidad and Tobago (from 15 percent to 17 percent). In the case of Barbados, the

required reserve ratio for both local deposits and government securities— which, in combination,

was last changed from 17 percent to 15 percent in 2007— is considered.

The second variable is the prime lending rate, plr

, which is used to represent commercial

banks’loan rate. The prime lending rate interacts with all the variables in the model except

non-fuel world CPI and world oil prices;

ECOTRIM is a program that supports temporal disaggregation of high frequency data from low frequency

data.

All indices were rebased to 2000.

The short-term interest rate rule is referred to as a "Taylor-type" rule because it is the conventional form

of the original Taylor (1993) policy rule.

As mentioned in Section II, the Central Bank of Barbados speci…es a reserve ratio for local currency deposits,

foreign currency dep osits and government securities. Over the period of this study, the reserve ratio on local

currency deposits did not change. As a result of this, the statutory ratio on government securities was considered,

in addition to the requirement on local currency deposits.

The third variable is the interest rate spread, spread

, which is measured as the di¤erence

between commercial banks’prime lending rate and the deposit rate. This variable captures

features of Caribbean countries in which wide interest rate spread re‡ects the oligopoly in‡u-

ence, risk and liquidity in the banking sector. The spread interacts with all the variables in the

model except non-fuel world CPI and world oil prices;

The fourth variable is the real exchange rate, exch_rate

. To measure this, the nominal

rate (Bds$/US$; J$/US$; TT$/US$) is de‡ated by U.S. CPI to obtain the real e¤ective rate.

The exchange rate interacts with all the variables in the model except non-fuel world CPI and

world oil prices;

The …fth variable is the change in private sector credit, cr edit

, which is used to capture

the role of credit in funding economic activities. Except for non-fuel world CPI and the world

price of oil, private sector credit also interacts with all the variables in the model;

The sixth variable is the growth rate of government expenditure, govt_exp

, which is in-

cluded to capture demand pressures associated with public expenditure. This variable reacts

with output growth, the policy interest rate, the exchange rate, world non-fuel CPI, world oil

prices and its past value. Total expenditure is used because changes in monetary policy can

a¤ect interest payments on domestic debt, and subsequently overall government expenditure;

The seventh variable is the ratio of excess reserves to total reserves, ertr

, which is used as

a measure of excess liquidity in the banking system. This variable interacts with all the others

in the model except non-fuel world CPI and the world price of oil;

The eight and ninth variables— non-fuel world CPI, world_CP I

, and the world price of

oil, oil_price

— are included to control for the in‡uence of external factors on the domestic

economy. The non-fuel world CPI accounts for the fact that because the economies are small

and open, in‡ation is strongly in‡uenced by foreign in‡ation; and the annual (year-on-year)

rate of change in the world price of oil captures the e¤ects of changes in energy prices on the

domestic economy. The non-fuel world CPI depends on its past value and the oil price, while

the world price of oil only depends on its past value and is not in‡uenced by any domestic

variables.

The lagged values of all the variables in the Partially Interactive block a¤ects the variables

in the Fully Interactive block.

The Real Exchange Rate (RER) is derived using the following formula:

RER=NER(US CPI=CPI for each country); where NER is the Nominal Exchange Rate. Watson (2003)

also used a similar approach in his empirical study to capture the dynamics of the exchange rate channel in the

monetary transmission mechanism of Trinidad and Tobago.

B.3. Strictly Exogenous Variables

This block consists of three variables:

A constant term;

A time trend; and

Eleven seasonal dummies are included to capture the e¤ect of seasonality on the variables.

B.4. Relationship of Variables

All the variables in the model are important to capture the characteristics of small open

economies and to examine the transmission of monetary policy. The two key instruments

used in the Caribbean to e¤ect monetary policy are a short-term interest rate and the reserve

requirement ratio. Usually, central banks adjust the short-term interest rate taking information

on in‡ation and output growth into account. Therefore, a policy rule, that takes the form of

a conventional Taylor-type rule is used in the framework. Changes in the short-term interest

rate are expected to have a direct impact on the term structure of interest rates in the banking

sector. This e¤ect is expected to be captured through the loan rate and the interest rate spread.

Also, owing to the fact that in the Caribbean commercial banks are the dominant source of

credit to the private sector, this is accounted for through the ratio of private sector credit to

GDP. The reserve requirement ratio is included to capture the e¤ects of a direct policy instru-

ment. It is important to include a measure of excess bank liquidity because the banking system

in the Caribbean has persistently recorded high excess reserves, which impairs the transmission

of monetary policy. It has been observed that quite often reserve requirements are adjusted to

alleviate liquidity pressures.

The real exchange rate is included because in an open economy, monetary policy is trans-

mitted through the exchange rate channel. Therefore, higher domestic interest rates should

result in an increase in demand for the local currency and an in‡ow of capital. It is important

to include a proxy for the …scal authority in the model because the e¤ectiveness of monetary

policy can be constrained by the actions of the government— to some extent. For instance, as

previously noted, it has been observed that the governments’…scal operations have contributed

to excess bank liquidity in Barbados, Jamaica and Trinidad and Tobago. Also, changes in do-

mestic interest rates and the exchange rate have an impact on government expenditure because

The series which displayed seasonality were deseasonalized using the X-12-ARIMA seasonally adjustent

method. An estimation of the model for each country using the deseasonalized series shows no signi…cant

di¤erence in comparison to the results from the mo d el with seasonal dummies. This indicates that the …ndings

are robust.

they a¤ect interest payments on domestic and external debt. Furthermore, the small and very

open nature of these economies make them susceptible to external shocks, particularly related

to high food prices and the volatility of energy prices. To control for the in‡uence of external

factors on the domestic economy, the non-fuel world CPI and oil prices are included. Domestic

in‡ation, output growth and government expenditure are directly a¤ected by international food

prices and energy price shocks.

Overall, the model includes the dynamic interaction of the main sectors: (1) the real sector,

proxied by growth in real output and the in‡ation rate; (2) the (commercial) banking sector,

which is proxied by a measure of credit, the ratio of excess reserves to total reserves, the prime

lending rate and the interest rate spread; (3) the external sector represented by the real exchange

rate; (4) the monetary authority, whose action is proxied by the short-term interest rate and

the required reserve ratio; and (5) the government’s …scal operations, which are captured by

the change in government expenditure.

The sample comprises monthly data from May 2002 to September 2014. Data were con-

strained to this period because the policy rate was implemented in Trinidad and Tobago in

2002. Also, during the period, the central banks relied more on market-based tools to e¤ect

monetary policy. The main data sources are The Central Bank of Barbados, The Central Bank

of Jamaica, The Ministry of Finance of Jamaica, and The Central Bank of Trinidad and Tobago.

To determine the stationarity properties of the individual time series, the Augmented Dickey

Fuller (ADF) and Phillips-Perron (PP) tests were used. In addition, seasonality tests were

conducted on each variable. The results from these tests are summarized in Table 1. The

optimal endogenous lag length is two based on the Akaike Information Criterion and Final

Prediction Error. Thus, using two lags on all endogenous variables, the reduced form of the

VARX model used in this study can be given by,

= A

t1

+ A

t2

+ C:D

+ u

: (2)

In the baseline case, where the policy_rate

is the instrument of monetary policy, the A

matrix is restricted such that:



1;1



1;2



1;3



1;4



1;5



1;6



1;7



1;8



1;9



1;10



1;11



2;1



2;2



2;3



2;4



2;5



2;6



2;7



2;8



2;9



2;10



2;11



3;1



3;2



3;3

0 0 0 0 0 0 0 0



4;1



4;2



4;3



4;4



4;5



4;6



4;7



4;8



4;9

0 0



5;1



5;2



5;3



5;4



5;5



5;6



5;7



5;8



5;9

0 0



6;1



6;2



6;3



6;4



6;5



6;6



6;7



6;8



6;9

0 0



7;1



7;2



7;3



7;4



7;5



7;6



7;7



7;8



7;9

0 0



8;1

0 

8;3

0 0 

8;6

0 

8;8

0 

8;10



8;11



9;1



9;2



9;3



9;4



9;5



9;6



9;7



9;8



9;9

0 0

0 0 0 0 0 0 0 0 0 

10;10



10;11

0 0 0 0 0 0 0 0 0 0 

11;11

output_g row th

tp

inf l

tp

policy_rate

tp

plr

tp

spread

tp

exch_rate

tp

credit

tp

govt_ exp

tp

ertr

tp

world_CP I

tp

oil _price

tp

Notes: 

(ij = 1; 2:::), are the coe¢ cients on the vector of endogenous variables; p = 1; 2 in

this model; In the second case, the rr r

is included in the model as the instrument of monetary

policy and it depends only on its past value. Regarding its order, the rrr

is placed after the

policy_rate

IV. Econometric Results

This section discusses the dynamic impact of a one-standard deviation positive shock to the

policy rate and the required reserve ratio using Lütkepohl, Krätzig and Boreiko’s impulse

response functions and variance decompositions.

The solid lines in …gures 1, 3, 5, 7, 9, and 11

(see Appendix) show the impulse response functions, while the dotted lines are the associated

95 percent upp er and lower con…dence bands calculated using the bootstrap method.

In the

baseline case, the policy interest rate follows a Taylor-type rule where it responds to output

growth, in‡ation and its past value. In the alternative experiment, the required reserve ratio is

included in the model and it responds only to its previous value.

A. Shock to the Policy Rate

In summary, the results show that in Barbados an increase in the short-term interest rate is

not successful in reducing output growth and in‡ation. Also, although a higher policy interest

rate has a direct positive e¤ect on the loan rate and it lowers the interest rate spread, it is not

See Lütkepohl and Krätzig (2004) and Lütkepohl et al. (2006).

The JMulTi econometrics software was used to estimate the mo d el.

successful in reducing credit growth. In Jamaica, a shock to the policy rate leads to a signi…cant

(temporary) fall in both output and excess reserves. The shock, however, has no signi…cant

e¤ect on the loan rate and the interest rate spread, implying therefore that there can be other

factors that in‡uence how banks determine their interest rates. In the case of Trinidad and

Tobago, an increase in the policy rate has a weak transmission to output growth and it is not

successful in reducing in‡ation. Also, a higher short-term interest rate leads to an exchange

rate appreciation and it has an immediate positive e¤ect on the loan rate. Further discussions

of the results are presented below.

A.1. Barbados

Figure 1 shows the results of a one-standard deviation shock to the p olicy rate. The impulse

response functions show that output growth contracts insigni…cantly at …rst, then ‡uctuates

over the period.

Initially, in‡ation falls marginally before increasing signi…cantly. This result

is consistent with other studies which have noted that interest rate changes in Barbados have

little or no e¤ect on prices (see for instance, Worrell et al. (2012)). Nonetheless, changes in

the policy rate leads to a direct increase in the prime lending rate. Because the policy rate

is the minimum deposit rate, an increase in this rate reduces the interest rate spread by 0:26

percent. One reason attributed for this is because banks hold excess liquidity, they can be

less inclined to increase loan rates. Further the increase in domestic interest rates leads to an

increase in demand for local currency and causes a statistically signi…cant appreciation of the

real exchange rate in the second month following the shock. This e¤ect is not persistent, and

so the exchange rate returns to its long run equilibrium level after the …fth period. Although

the prime lending rate increases, credit falls marginally in the …rst period following the shock;

this response however is not signi…cant. Also, an increase in the policy rate causes government

expenditure to rise signi…cantly by 0:14 percent, but the e¤ect of the shock quickly dissipates.

This result is consistent with the …ndings from Moore and Skeete (2010) which noted that

because of the positive correlation between interest rates on government paper and those set

by the Central Bank of Barbados, a positive monetary policy shock can increase domestic debt

servicing costs. The ratio of excess reserves to total reserves falls signi…cantly after 5 months

as a higher short-term interest rate causes banks to reduce demand for excess reserves.

The variance decompositions of the domestic variables are presented in Figure 2. The results

show that ‡uctuations in real GDP account for about 87 percent of its own innovations, and

6 percent of world oil prices. Variations in in‡ation contributes between 95 percent and 40

percent of its own innovation, about 20 percent of non-fuel world CPI and 15 percent of world

oil prices. This provides evidence that foreign prices determine domestic in‡ation in small open

economies. Also, in‡ation is a¤ected to a lesser extent by output growth and the policy rate.

Similarly, the …ndings from a study on Nigeria by Onyukwu and Nwosu (2011) showed that under a market-

based policy, a monetary policy shock leads to persistent volatility in output growth.

Changes in the prime lending rate are in‡uenced primarily by both its own shock (45 percent)

and the policy rate (50 percent). The results for the interest rate spread show that its past value

accounts for 40 percent of the ‡uctuations, while the policy rate and the prime lending rate

account for 30 percent and 25 percent of the ‡uctuations, respectively. For the real exchange

rate, about 50 percent of the ‡uctuations can be attributed to its own innovation and in‡ation

accounts for 40 percent. To a lesser extent, variations in the policy rate also a¤ect the real

exchange rate, implying therefore that an increase in domestic interest rates can induce demand

for local currency, thereby in‡uencing capital ‡ows. Furthermore, own innovations contribute

mainly to changes in private sector credit growth, as well as excess liquidity and the policy

rate, to a smaller extent. Government expenditure is determined mainly by its previous value,

85 percent, and the policy rate accounts for about 8 percent of the changes. Finally, variations

in the ratio of excess reserves to total reserves mainly result from its own innovation (95 to 85

percent), and to a lesser extent, government expenditure and the policy rate.

A.2. Jamaica

Figure 5 shows the results of a one-standard deviation shock to the policy rate, which in this

case is the 30 day open market rate. An increase in the policy rate under a Taylor-type rule leads

to a marginal decline in output by 0:03 percent. In‡ation also declines, but this e¤ect is not

signi…cant. Similar to the case of Barbados, the interest rate spread falls because the increase in

the deposit rate is greater than the rise in the prime lending rate. However, in this case, the e¤ect

on the prime lending rate and the interest rate spread is insigni…cant. Interestingly, following

the shock, the real exchange rate depreciates by 0:05 percent. Although this result is contrary

to a priori expectations, it is possible because in the presence of credit market imperfections,

a positive monetary policy shock can lead to an exchange rate depreciation (see Agénor and

Montiel (2007) and Sen Min (2008) for similar results). It should also be noted that during

the period of this study, there has been a signi…cant depreciation of the nominal exchange rate

in Jamaica. This can therefore imply that the interest rate must be increased substantially to

induce the demand for local currency. Additionally, on impact of the shock, private sector credit

increases before decreasing, and the fall in private sector credit is signi…cant during the …fth to

seventh months, and after the eleventh month. The slow change in credit growth can be due to

the fact that borrowers may be unable to …nd alternative sources of funding, and will therefore

continue to borrow at relatively higher interest rates. It has also been noted that in small open

economies, an increase in bank loan rates does not cause loan demand to fall substantially (see

Worrell (1995)). Consistent with the results from Barbados, government expenditure increases

signi…cantly after 4 months. As a higher policy rate causes banks to reduce demand for excess

reserves, the quantity of liquidity falls by 0:07 percent in the second month. This result is

similar to a study by Primus (forthcoming) that found a contractionary monetary policy shock,

resulting from an increase in short-term interest rates, raises the opportunity cost of holding

excess reserves, thereby, lowering the level of excess liquidity in the banking system.

Figure 6 illustrates the corresponding variance decompositions of a shock to the policy rate.

The …ndings reveal that ‡uctuations in output account for 100 percent of its own innovation

in the …rst month and declines gradually over the period to 75 percent. Also, world oil prices

and the policy rate can explain 8 percent and 6 percent, respectively of the variation in output.

For in‡ation, changes are due solely to its past value in the …rst period, and this contribution

declines consistently thenceforth. In addition, variation in world oil prices and the ratio of excess

reserves to total reserves contribute to changes in domestic prices. This therefore indicates that

higher excess liquidity can put pressure on prices in Jamaica. Changes in the prime lending rate

are mainly the e¤ects of its own innovations (82 percent), as well as the interest rate spread and

output growth. Given that the policy rate does not contribute substantially to ‡uctuations in

loan rates, this can explain why its e¤ect is insigni…cant in the impulse response function. Also,

the prime lending rate is responsible for approximately 75 percent of the variation in the interest

rate spread. Fluctuations in the exchange rate contribute to 85 percent of its own innovations in

the …rst period, but then decline gradually to about 45 percent. Changes in the exchange rate

can also be explained by the policy rate, in‡ation and output growth. Furthermore, the …ndings

reveal that growth in private sector credit are due mainly to its own innovation (65 percent),

and to a lesser extent, the policy rate and the ratio of excess reserves to total reserves. For

government expenditure, variations arise mainly because of its past value (86 p ercent), while

changes in the policy rate and world oil prices both account for approximately 4 percent of

the changes. Regarding the ratio of excess reserves to total reserves, about 70 percent of the

‡uctuations can be explained by its own innovation, as well as the policy rate, world oil prices

and government expenditure, to a smaller extent.

A.3. Trinidad and Tobago

Figure 9 shows the simulations of a one-standard deviation shock to the policy rate. If there

is an increase in the ‘repo’rate, output growth rises before declining signi…cantly during the

tenth and fourteenth months. Thus, there is a slow transmission of changes in the policy rate

to output. Interestingly, following the shock, it is observed that in‡ation rises and remains

signi…cant during the …fth and tenth months, before declining gradually. The hump-shaped

pattern is consistent to what is described as the price puzzle e¤ect which is common in VAR

models. See Walsh (2010) for a discussion on the price puzzle e¤ect and Davoodi et al. (2013) for

similar …ndings in the East African community. Also, a higher policy rate has an instantaneous

e¤ect on commercial banks prime lending rate, which rises by 0:09 percent following the shock.

Although the prime lending rate increases, the deposit rate does not rise in tandem, causing

the interest rate spread to widen— amid high excess liquidity. As reported in the International

Monetary Fund (2011), deposit rates in Trinidad and Tobago are more resp onsive to cuts in

the ‘repo’policy rate, than increases. Similarly, as shown in Lebedinski (2007) and Agénor and

El Aynaoui (2010), because banks hold excess liquidity, deposit interest rates are more sticky

upward.

The in‡ow of capital resulting from a higher policy rate, increases demand for the local

currency, and in turn leads to a signi…cant appreciation of the exchange rate in the second

period. The appreciation dissipates after the sixth p eriod, so the exchange rate returns to its

equilibrium level. This result is similar to a study by Watson (2003) that found an increase

in the Treasury bill rate in Trinidad and Tobago is accompanied by a real exchange rate ap-

preciation. In addition, private sector credit falls in the …rst month following the shock, albeit

insigni…cantly. This can be attributed to the fact that because commercial banks are the main

intermediaries, credit demand is not severely a¤ected by changes in the prime lending rate.

Government expenditure increases 2 months after the shock by 0:06 percent as a higher policy

rate raises interest rates on government paper, thereby resulting in increased interest payments

and overall expenditure. Also, changes in the policy rate lead to a decline in the ratio of excess

reserves to total reserves, but this e¤ect is not signi…cant.

The variance decompositions of the domestic variables are presented in Figure 10. The

results indicate that ‡uctuations in real output are initially due to 100 percent of its own

innovations but declines consistently to 55 percent, whereas the contribution of in‡ation is

more apparent after the seventh month. GDP growth is also a¤ected by changes in the policy

rate and the ratio of excess reserves to total reserves. For in‡ation, ‡uctuations are mainly

because of its own innovations, as well as the policy interest rate and changes in world oil

prices. The results for the prime lending rate show that its own shocks contribute to about 60

percent of the variations overall, and approximately 25 percent is due to changes in the policy

interest rate. To a lesser extent, changes in private sector credit and the ratio of excess reserves

to total reserves a¤ect the prime lending rate. Fluctuations in the interest rate spread account

for approximately 55 percent of its own innovation, 30 percent of the prime lending rate and

12 percent of the policy interest rate. Changes in the exchange rate results from 50 percent

‡uctuations in its own innovations and 40 percent in in‡ation. Notably, although changes in

the policy rate a¤ect capital ‡ows, its contribution to the movement in the exchange rate is

not substantial (less than 10 percent). Variations in private sector credit re‡ect mostly its own

shocks (about 85 percent) and, to a small extent, changes in the prime lending rate, the policy

interest rate, and output growth. Regarding government expenditure, its own innovations

contribute 85 percent to the changes, while the policy rate is responsible for about 9 percent.

For the ratio of excess reserves to total reserves, approximately 80 percent of the ‡uctuations

depends on its past value, 10 percent is due to in‡ation and the exchange rate is responsible

for 5 percent. It is important to note that although the government’s …scal operations is a

key contributory factor to excess liquidity in Trinidad and Tobago (see Primus et al. (2014)),

government expenditure accounts for less than 5 percent of the changes in excess reserves.

B. Sho ck to the Reserve Requirement Ratio

Overall, the results show that in the case of Barbados, a higher required reserve ratio is successful

in reducing in‡ation, implying therefore that more direct policy tools can help to contain

in‡ationary pressures in Barbados. In Jamaica, although higher reserve requirements has no

e¤ect on output, it leads to a signi…cant reduction in in‡ation during the …rst period following

the shock. In Trinidad and Tobago, an increase in the required reserve ratio leads to an

immediate signi…cant drop in output growth. The reserve requirement shock is also successful

in reducing both private sector credit and excess reserves. The rest of this section provides

further discussions of the results.

B.1. Barbados

Figure 3 presents the e¤ect of a one-standard deviation shock to the required reserve ratio.

The impulse response functions show that output growth contracts temporarily after 4 months

before rising, but similar to the baseline case of a shock to the policy rate, the e¤ect on output

is not signi…cant. By contrast to the results in Figure 1, higher reserve requirements leads to

a signi…cant fall in in‡ation after 9 months. Also, the prime lending rate increases in the …rst

period as the baseline case. However, the e¤ect is insigni…cant under the shock to the required

reserve ratio. Furthermore, in this case, on impact of the shock the interest rate spread increases

by 0:17 percent because higher reserve requirements causes banks to reduce their deposit rates

and increase their loan rates. This …nding is similar to other studies that found a positive shock

to the required reserve ratio acts as a tax on banks so the spread between lending and deposit

rates increases; see for instance Montoro and Moreno (2011), Glocker and Towbin (2012), Tovar

et al. (2012), and Primus (forthcoming). The real exchange rate depreciates signi…cantly after

7 months. It is important to note that an increase in the required reserve ratio does not have

a signi…cant e¤ect on credit demand and government expenditure. Also, contrary to what is

expected, the ratio of excess reserves to total reserves increases one month after the shock

by 0:09 percent before declining; however, the fall in excess reserves is not signi…cant. In

Barbados, a higher required reserve ratio on local currency deposits is more likely to be caused

by an increase in the security requirement. Under this circumstance, commercial banks are

likely to demand more excess reserves as this can be an opportunity for them to switch excess

idle funds to interest earning securities.

The corresponding variance decompositions of a shock to the required reserve ratio are

shown in Figure 4. An examination reveals that in most cases, the results are similar to the

baseline case of a positive shock to the policy rate (Figure 2). For output growth, world oil

prices account for a marginally smaller share of the ‡uctuations (less than 5 percent). In this

case, variations in in‡ation are attributed to about 2 to 4 percent in the required reserve rate

after the seventh period, whereas the policy rate can explain 2 to 8 percent of in‡ation in the

baseline experiment. The contribution of own innovations to the prime lending rate is similar

under both experiments (45 to 52 percent). Further, in this experiment, changes in the interest

rate spread can be explained less by the required reserve ratio (10 percent), as opposed to the

baseline case in which 30 to 38 percent of the variation is attributed to the policy rate. It should

be noted that movements in the exchange rate and private sector credit can be attributed less

to the required reserve ratio, than the policy rate— when it is the instrument of monetary

policy. Similarly, the results show that changes in government expenditure depend to a lesser

extent on the policy instrument in this case, as only 3 percent is determined by the required

reserve ratio, compared to 8 percent in Figure 2. In comparison to the shock to the policy rate,

reserve requirements account for a larger share of the movement in the ratio of excess reserves

to total reserves (22 percent), implying therefore that this is an appropriate policy tool that

can in‡uence bank liquidity.

B.2. Jamaica

The impulse response functions of a one-standard deviation shock to the reserve requirement

ratio are presented in Figure 7. The impulse response functions indicate that output falls

following the shock, but unlike the baseline case of a shock to the policy rate (Figure 5), this

e¤ect is insigni…cant. Also, on impact of the shock, in‡ation falls by 0:4 percent, but only

remains signi…cant in the …rst period. Although the e¤ect on in‡ation is short-lived, this result

indicates that reserve requirements can be used as a policy tool for price stability. The interest

rate spread falls by 0:09 percent as a higher required reserve ratio reduces the deposit rate, but

does not increase the lending rate signi…cantly. Similar to the results in Figure 5, if there is

an increase in the required reserve ratio, the exchange rate depreciates and credit falls from

the second month. Furthermore, government expenditure falls in the …rst p eriod and then rises

almost signi…cantly after 4 months. In the second month following the shock, the ratio of excess

reserves to total reserves falls by marginally more than the baseline case, implying therefore

that changes in the reserve requirement ratio have a stronger e¤ect on bank liquidity.

Figure 8 shows the variance decompositions of a shock to the required reserve ratio. An

inspection of the results show that they appear similar to the case of a shock to the p olicy

rate (Figure 6). For output growth, the required reserve ratio can explain less than 0:5 percent

of the ‡uctuations, in comparison to the baseline case in which the policy rate accounts for

approximately 6 percent. Regarding in‡ation, changes in world oil prices can explain a slightly

lower share of its ‡uctuations under a shock to reserve requirements, whereas the contribution

of non-fuel world CPI is about the same under both shocks. In addition, the results show

that more of the variations in the prime lending rate, the interest rate spread, and government

expenditure, can be explained by the required reserve ratio, as compared to the policy interest

rate. However, reserve requirements contribute to a slightly lower share of the variation in

the exchange rate. Similarly, for private sector credit, the required reserve ratio can only

explain about 3 percent of its ‡uctuations, as opposed to the baseline case in which the policy

rate accounts for about 10 percent of its changes. Also, when there is an increase in reserve

requirements, government expenditure contributes a slightly lower share to the movements in

the ratio of excess reserves to total reserves in comparison to the baseline case.

B.3. Trinidad and Tobago

Figure 11 presents the results of a one-standard deviation shock to the required reserve ratio.

In this case, in the second month, output falls signi…cantly by 0:05 percent, in contrast to

an increase of 0:07 percent with a shock to the p olicy rate (Figure 9). In‡ation also rises in

this experiment but the e¤ect is insigni…cant. Both the prime lending rate and the interest

rate spread increase in the third month, in comparison to an increase in the …rst month in the

baseline case. Further, an increase in the required reserve ratio does not have a signi…cant e¤ect

on the real exchange rate and government expenditure. However, private sector credit contracts

by 0:05 percent in the second month following the shock. Importantly, if there is an increase in

reserve requirements, the ratio of excess reserves to total reserves falls by 0:18 percent in the

second month, contrary to the baseline case where an increase in the policy rate did not lead

to a signi…cant reduction in the ratio of excess reserves to total reserves.

Figure 12 shows the variance decompositions of a one-standard deviation shock to the reserve

requirement ratio. Overall, the results do not di¤er signi…cantly to the shock to the policy

interest rate. In this case, world oil prices can explain about 1 percent in the real output

growth, unlike the baseline case (Figure 10) in which it accounted for up to 5 percent of the

‡uctuations. The contribution of the required reserve ratio to changes in output and in‡ation

is far less substantial, in comparison to the policy rate. This …nding is contrary to a study

by Ramlogan (2007) that found reserve requirements are important in explaining variations

in output and in‡ation. Also, for the prime lending rate, the interest rate spread, the real

exchange rate and government expenditure, the reserve requirement ratio accounts for less

of the ‡uctuations, as compared to the policy interest rate in the baseline experiment. For

instance, in Figure 12, regarding the interest rate spread, the required reserve ratio contributes

to less than 5 percent of the variations, whereas in the baseline case, the policy rate accounts

for 12 percent of the changes. However, the results for private sector credit and the ratio of

excess reserves to total reserves show that the required reserve ratio can explain more of the

‡uctuations (about 7 percent and 8 percent, respectively), in comparison to the shock to the

policy rate where it is only responsible for 3 percent and 0:9 percent, respectively of the changes.

V. Conclusion and Policy Implications

The purpose of this study was to investigate the relative e¤ectiveness of indirect and direct

monetary policy tools in transmitting monetary impulses in Barbados, Jamaica and Trinidad

and Tobago. A Taylor-type short-term interest rate was used as the indirect p olicy instrument

and the required reserve ratio represented the direct policy tool. To conduct this analysis, the

study estimated a restricted Vector Autoregressive model with Exogenous Variables (VARX),

which incorporated the various sectors of the economy. The model also accounted for the

imperfections in the …nancial sector in those countries— in particular, excess bank liquidity and

credit market imperfections.

Overall, the results show that there is a weak transmission of changes in the policy interest

rate because of high …nancial system liquidity. An analysis of the impulse response functions

reveals that although an increase in the short-term interest rate has an instantaneous e¤ect

on commercial banks’ loan rates in Barbados and Trinidad and Tobago, this e¤ect does not

translate into a signi…cant fall in private sector credit. Also, higher domestic interest rates

leads to an appreciation of the real exchange rate and an increase in government expenditure

in both countries. By contrast, in Jamaica, a higher policy rate leads to a real exchange rate

depreciation, and a marginal signi…cant increase in government expenditure after 5 months.

The …ndings also show that in all three countries, the shock has a muted e¤ect on in‡ation,

which indicates that changes in the short-term interest rate are not su¢ cient to achieve price

stability. Following the shock, output contracts immediately in Jamaica, but it takes 10 months

for a fall in output to be realized in Trinidad and Tobago.

Moreover, a contractionary monetary policy shock via a higher required reserve ratio is

successful in reducing credit demand and it leads to an instantaneous fall in excess reserves in

Jamaica and Trinidad and Tobago. Also, in Trinidad and Tobago, higher reserve requirements

can help to reduce output growth faster, and it does not create pressure on the exchange

rate. Furthermore, in Barbados, an increase in the required reserve ratio has no e¤ect on the

government’s interest payments and it leads to a signi…cant depreciation of the exchange rate

after the seventh period.

These results therefore reveal that the central banks of Barbados, Jamaica and Trinidad

and Tobago should use a combination of indirect and direct policy tools to e¤ect monetary

policy. Thus, although the monetary authorities in those countries are employing market-based

measures, indirect policy instruments are not su¢ cient to transmit monetary impulses to key

macroeconomic variables. Furthermore, the monetary authorities should adjust reserve require-

ments on local currency deposits more frequently as this has a direct e¤ect on credit demand

and excess reserves— and this action is not associated with an increase in interest costs. This

result can be particularly imp ortant for Barbados, as that country has not changed the require-

ment on local currency deposits for over a decade. Also, similar to Barbados and Jamaica, the

Central Bank of Trinidad and Tobago should consider implementing reserve requirements on

securities. This is because by manipulating the requirement on securities, the Central Bank

can in‡uence other short-term rates, and help to better manage liquidity conditions.

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Table 1. Unit Root and Seasonality Tests

Barbados

Jamaica

Trinidad and Tobago

Variable

Order of

Integration

Seasonal

Dummies

Trend

Order of

Integration

Seasonal

Dummies

Trend

Order of

Integration

Seasonal

Dummies

Trend

output_growth

I(1)

I(0)



infl

I(0)

policy_rate

I(1)

rrr

I(0)

I(1)

plr

I(1)

d10

I(1)

spread

I(0)



I(1)

d11

exch_rate

I(1)

d1, d3, d8

I(0)



I(1)

credit

I(1)

govt_exp

I(0)



I(0)

ertr

I(1)

I(0)



I(0)

world_CPI

I(0)

oil_price

I(0)

Barbados

One-Standard Deviation Shock to the Policy Interest Rate

Figure 1. Impulse Response Functions

Barbados

One-Standard Deviation Shock to the Policy Interest Rate

Figure 2. Variance Decompositions

Barbados

One-Standard Deviation Shock to the Reserve Requirement Ratio

Figure 3. Impulse Response Functions

Barbados

One-Standard Deviation Shock to the Reserve Requirement Ratio

Figure 4. Variance Decompositions

Jamaica

One-Standard Deviation Shock to the Policy Interest Rate

Figure 5. Impulse Response Functions

Jamaica

One-Standard Deviation Shock to the Policy Interest Rate

Figure 6. Variance Decompositions

Jamaica

One-Standard Deviation Shock to the Reserve Requirement Ratio

Figure 7. Impulse Response Functions

Jamaica

One-Standard Deviation Shock to the Reserve Requirement Ratio

Figure 8. Variance Decompositions

Trinidad and Tobago

One-Standard Deviation Shock to the Policy Interest Rate

Figure 9. Impulse Response Functions

Trinidad and Tobago

One-Standard Deviation Shock to the Policy Interest Rate

Figure 10. Variance Decompositions

Trinidad and Tobago

One-Standard Deviation Shock to the Reserve Requirement Ratio

Figure 11. Impulse Response Functions

Trinidad and Tobago

One-Standard Deviation Shock to the Reserve Requirement Ratio

Figure 12. Variance Decompositions