Foreign Exchange Pressure in Barbados: Monetary Approach or Monetary Dependence?

This paper tests competing ideas that account for the foreign exchange (FX) losses in Barbados in recent years. The conventional monetary and absorption approaches have motivated the explanation and policy proposals to date. However, this paper illustrates that the conventional theories fail to completely account for the external forces determining FX pressure. We propose a theory of monetary dependency by integrating the basic insight of the Prebisch-Singer hypothesis into an institutionally consistent monetary framework. The model implies that the narrow policy space in the short run is overwhelmed by the falling FX supply in the long term - hence the long-term FX constraint which prevents complete adjustment as predicted by the reflux mechanism. Although Barbados is the case study - given its recent program with the IMF - the model of monetary dependence is applicable, in general, to other small open developing and emerging economies. The econometric results indicate tenuous support for the monetarist theory, but stronger evidence in favor of the monetary dependency theory, and indirect support for the absorption approach. Consistent with the idea of external determination, the trade-weighted American dollar exchange rate and its conditional volatility are the strongest determinants.