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Essays on Monetary and Fiscal Policies in Small Open Economies: The Case of Trinidad and Tobago

Primus, Keyra

[Thesis]. Manchester, UK: The University of Manchester; 2014.

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Abstract

Trinidad and Tobago is a small open economy that faces macroeconomic policy challenges which are related to imperfections in the financial sector and volatility of energy sector revenues. Specifically, two of the key issues policymakers are grappling with are high levels of excess reserves and the optimal management of the economy's resource revenues—in the face of domestic and external shocks to the energy sector. This thesis uses a general equilibrium modeling approach to examine the dynamic effects of these policy challenges on the Trinidad and Tobago economy. In the first case, this study examines the financial and real effects of excess reserves in a New Keynesian Dynamic Stochastic General Equilibrium model with monopoly banking, credit market imperfections and a cost channel. The model explicitly accounts for the fact that banks in Trinidad and Tobago hold excess reserves and they incur costs in holding these assets. Simulations of a shock to required reserves show that although raising reserve requirements is successful in sterilizing excess reserves, it creates a procyclical effect for real economic activity. This result implies that financial stability may come at a cost of macroeconomic stability. The findings also indicate that using an augmented Taylor rule in which the policy interest rate is adjusted in response to changes in excess reserves reduces volatility in output and inflation but increases fluctuations in financial variables. To the contrary, using a countercyclical reserve requirement rule helps to mitigate fluctuations in excess reserves, but increases volatility in real variables. Moreover, this research uses an open economy Dynamic Stochastic General Equilibrium model to analyze the transmission of resource price shocks and a shock to resource production in the Trinidad and Tobago economy. It also applies alternative fiscal rules to determine the optimal allocation of resource windfalls between spending today and saving in a sovereign wealth fund. The results show that spending all the resource windfall on consumption and investment creates more volatility and amplifies Dutch disease effects, when compared to the case where all the excess revenues are saved. Also, neither a policy of full spending nor full saving of the surplus revenue inflows is optimal if the government is concerned about both household welfare and fiscal stability. In order to minimize deviations from both objectives, the optimal fiscal response suggests that a larger fraction of the resource windfalls should be saved, than what the government is presently saving.