Control must be maintained on Barbados’ appetite for goods and services to ensure the island doesn’t develop a foreign exchange problem.
Central Bank of Barbados Governor Dr. DeLisle Worrell said this consumer desire, known as aggregate demand in the economics fraternity, was the best option for a small very open economy like Barbados, and he also ruled out the International Monetary Fund-prescribed currency devaluation as a viable alternative.
The economist made the assertions in a new working paper on the topic Exchange Rate Targetting Through Aggregate Demand Management.
He asserted that since most of the island’s consumption was of imported items, and domestic production also used imported inputs “very heavily” the impact of such purchases on the country’s foreign reserves was something which needed to be controlled at all times, but especially during periods of economic difficulty.
“The tool that remains to the authorities for aggregate demand management is the size of the fiscal deficit and the extent of money creation to finance it. Small very open economies should therefore target the exchange rate, using fiscal policy to manage aggregate expenditure and the consequent spending on imports,” Worrell said.
He added that “the over-arching policy concern is to maintain an underlying balance between the fundamental demand and supply of foreign exchange over time”.
“In the short run that implies aggregate demand management, keyed on the expected availability of foreign exchange, to ensure that the import requirement is not in excess of that availability,” the Central Bank boss stated.
“In order to grow the economy, there must be investment and productivity increases in the sectors that earn and save foreign exchange, to satisfy the need for the additional imports which the growing economy will require.
“Focusing on the exchange rate anchor, and ensuring that the central bank maintains adequate reserves by managing aggregate demand, keeps the (small very open economy) on a sustainable growth path over time.”
Worrell said the effectiveness of such a policy to preserve and protect foreign exchange needed to ensure that “the underlying demand for foreign exchange in the economy must not exceed the available supply, so macroeconomic policy must be directed to ensure this balance”.
“This has to be achieved through the management of aggregate demand and supply, because foreign exchange rationing and changes in the relative price of foreign exchange will not produce the changes in volumes needed to equilibrate the external market,” he said.
“It is now generally accepted that the demand for foreign exchange may not be contained by controls or rationing on the current account, and I have argued elsewhere that the same is true of the capital and financial account.
“The elasticity conditions are not satisfied for a devaluation to bring about an equilibrium of foreign exchange demand and supply, and the current account responses to devaluation are invariably overwhelmed by capital flight. It follows that the demand for foreign exchange in the (small very open economy) can be brought into equilibrium with the supply only by way of aggregate demand management,” he added. (SC)