A Small Foreign Exchange Market With A Long-Term Peg; Barbados

Project and Seminar Material for Economics

Chapter One

Introduction

The extent of financial integration in the modern world, reflected in the magnitude and pervasiveness of financial flows, has served to intensify research on the economic functioning of foreign exchange markets. In the open economy, international financial flows will ensure that interest rate parity is maintained for assets of similar maturities, or that the interest differentials exactly reflect expectations about exchange rate changes, provided there are no frictions and externalities. The overwhelming majority of studies of the foreign exchange markets have explored whether exchange markets do function in this manner and, when they do not, what seems to account for the observed excess returns to foreign exchange speculation.

A variety of hypotheses have been tested to explain why interest premia are typically higher than may be anticipated on the basis of expectations of exchange rate changes.This literature has almost never focused exclusively on the behavior of the foreign exchange market in regimes where the exchange rate is pegged, although some studies (for example Flood and Rose, 2001) do include pegged exchange rate markets in their sample. That may be because comparatively few countries have maintained a pegged exchange rate for such a long period, and through such vicissitudes of economic circumstance, that market expectations of exchange rate changes are virtually zero.

This is a distinguishing characteristic of some currencies of smaller Caribbean countries, including the Barbadian dollar, the exchange market for which is the subject of the present study. In the absence of exchange rate uncertainty, inflows and outflows of foreign exchange should respond to interest differentials, in a way that maintains uncovered interest parity (UIP). We test whether the flow of foreign currency transactions in Barbados is motivated by UIP between Barbadian dollar assets and equivalent assets denominated in U.S. dollars, the currency to which the Barbadian dollar has been pegged at an unchanged value since July 1975. Our working hypothesis is that international financial flows, reflected in daily transactions in the foreign exchange market, serve to equilibrate the Barbadian interest rate to the U.S. equivalent, apart from structural features, market frictions, and imperfections, all of which can be accounted for in the estimation.