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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.

Thesis advisor: Peter Ireland / The literature on real business cycles finds that one reason why emerging economies are more volatile than developed small open economies is that they face greater financial frictions. Indeed, according to several measures of financial depth and access, financial systems in emerging countries are on average less developed than those in developed small open economies. Despite the lag in financial development, private credit, particularly unsecured credit to households, has been steadily increasing during the last two decades in emerging countries in Latin America. During this period of rising credit, various countries in the region observed an increase in the size of their middle income class population and the emergence of the vendor financing channel in their consumption credit market. Estimates by the World Bank suggest that the share of middle class households increased from 20.9 % in 1995 to 40.7 % in 2010. In addition, the share of poor households was approximately halved and reached 23.4 % at the end of this 15 year period. This phenomenon not only increased credit demand but also motivated the entry of new suppliers in the consumer credit market in countries like Mexico, Colombia, Chile and Brazil. In spite of a significant decline in unemployment in recent years, the lack of formal employment and poor credit history were still impeding many individuals from gaining access to consumer finance from traditional financial institutions. In order to enable new middle class shoppers access items typically offered by large retail stores, the retailers themselves started offering credit. In this dissertation, I study the relationship between middle class size, unsecured credit markets and aggregate consumption volatility in emerging countries. In the first chapter of this thesis, we examine the link between middle class size and consumption growth volatility using a sample of middle income countries. In the second chapter, we study the effect of an expansion of the middle class on vendor financing incentives and unsecured credit supply on its extensive margin. In the third chapter, I study business cycle implications of a reduction in the share of financially excluded households in an emerging economy. In the first chapter, I empirically examine the effect of middle income class size on consumption growth volatility in emerging countries. Using a panel data of middle income countries, I find that a larger middle class size tends to increase aggregate consumption growth volatility, particularly at lower levels of financial system depth. Financial development plays a significant role in determining the sign of the marginal effect of middle class size on aggregate volatility. Unlike emerging countries, the effect of the size of the middle class and the role of financial development on consumption volatility in developed countries is ambiguous. The key message of this analysis is that as more households escape poverty thresholds and reach the middle income class status in developing and emerging economies, it becomes more important to deepen financial systems from the perspective of aggregate consumption volatility. In the second chapter, I explore through the lens of a theoretical model, potential reasons triggering an increase in credit supplied by the non traditional financial sector, i.e vendors, at the extensive margin. I find that a reduction in the average risk of default and an increase in the market size of credit customers raise vendor financing incentives. This model rationalizes the observation that the improvement of economic conditions of the low-income and financially constrained households potentially led to increased credit supply by vendors in several countries of Latin America. In the third chapter, I study business cycle implications of a decline in household financial exclusion in a dynamic general equilibrium model suitable for emerging economies. Using Mexico as a case study, I estimate the model with Bayesian methods for the period 1995 to 2014. Standard measures of predictive accuracy suggest that the extended business cycle model with limited credit market participation outperforms a model with zero financial exclusion. The results of the estimation suggest that a rise in credit market participation in an emerging economy increases aggregate volatility of key macroeconomic aggregates, and that financial frictions play a key role in this relationship. I confirm this prediction by re-estimating the model for Mexico after splitting the sample into two non- overlapping decades. A key implication derived in this chapter is that a reduction of financial exclusion within an emerging country may lead to higher consumption growth volatility and trade balance volatility, and that fewer financial frictions dampen the marginal effect. As household financial access increases in these countries, a greater need for improving broad financial development measures arises.

This study analyzes the determination of the exchange rate system in a small economy when external real and monetary disturbances occur. Choice of exchange rate policy is investigated using a model assuming rational expectations and a loss function expressing the squared deviations of the small country output from desired output. The distinguishing feature of the analysis is the emphasis on real as well as monetary disturbances which originate abroad but are a source of domestic output variation. the link between foreign monetary and real disturbances and variance in output is traced using the thoretical model and the loss function assumed. The emphasis of the analysis is on a three country (one small and two large) trading situation, whereby the small country trades with two major large country trading partners. It is assumed throughout that there is perfect commodity arbitrage between two large countries. The small country imports an intermediate good from one of the large countries and exports a finished good. The small country doesnot import goods for consumption. there is perfect capital movement between two large countries, but capital is immobile between the small and these two large countries. The analysis indicates that occurrence of purely nominal shocks abroad are not transmitted to the small country under floating exchange rate system. The presence of real disturbances in large countries induce lower prices for the goods they produce, but the effect on the exchange rate is ambiguos. This study concludes that in general the adoption of a flexible exchange rate system by a small country is preferred and results in lower loss in most cases of external disturbance.

This study examines the relationship between unemployment rates and oil price, oil price uncertainty, and interest rates. This relation is examined by testing for both cointegration and causality between the variables. By employing the Autoregressive Distributed Lag (ARDL) method this study managed to examine the long-run cointegration between unemployment rates oil price, oil price uncertainty, and interest rates. A modification of the ARDL method is the error correction method which was used to find the short-run dynamics and the speed of convergence back to equilibrium after a shock. Fully modified ordinary least squares (FMOLS) regression was then applied to find the optimal estimates of the long-run coefficients for the regressions. The Toda-Yamamoto Granger causality test is used to find the direction of causality between the variables. These tests were conducted on Sweden, Norway, Denmark, and Finland on monthly data from January 2008 to February 2020. A cointegration relationship was found for Sweden, Norway, and Denmark. The long-run coefficients from the FMOLS regression showed that increased oil prices lead to increased unemployment rates for Sweden and Denmark. All countries except Denmark show evidence of causality from oil prices on unemployment indicating a strong relationship between these two variables. Some countries show causality from oil price uncertainty and interest rates on unemployment rates. These results provide important guidance for policymakers on how to design good economic policies.

Thesis advisor: Pablo Guerron-Quintana / This thesis consists of two self-contained essays on topics in applied macroeconomics. In the first chapter, I study how heterogeneous sensitivities to weather fluctuations and interregional production networks impact the measurement of weather shocks’ impact on economic activity in the United States. I start the analysis by building a general equilibrium model where the impact of weather fluctuations on productivity is state-sector dependent, and networks expose sectors to weather shocks from other regions through the use of intermediate inputs. Then, I quantify the relevance of these mechanisms, combining the model’s predictions with annual data on sectoral GDP and average temperatures by state from 1970 to 2019. My estimates show that models that do not consider these characteristics underestimate the aggregateimpact of weather fluctuations by at least a factor of 3. In particular, when the whole economy faces an unexpected increase in temperature of 1 Celsius degree, the contraction in economic activity increases from -0.13 to -0.37 percent once heterogeneity is considered and -1.14 percent when networks are included. In the second chapter, I propose a new methodology to disentangle between terms of trade movements caused by global shocks and those resulting from country-specific terms-of-trade fluctuations. This methodology extends the so-called maximum-share approach in two ways. Firstly, a global shock is identified as the shock with the highest explanatory power on the forecast error variance of a set of exogenous variables. This is in contrast to the typical approach of using only one variable as a source of information to identify a shock. Secondly, country-specific terms-of-trade shocks are identified as shocks that satisfy two conditions: (i) maximum explanation power on terms-of-trade variability and (ii) orthogonality to global shocks, allowing me to isolate the main drivers of terms of trade that are not related to global fluctuations. I apply this methodology to data on ten small open economies(SOEs) and show that global shocks contribute - on average- to 33 percent of their business cycle fluctuations. The contribution of global shocks to terms-of-trade variability is close to 20 percent, meaning that around 80 percent of terms-of-trade movements have country-specific origins. Interestingly, on average, country-specific terms-of-trade shocks are responsible for less than 10 percent of SOE business cycle variability. These results help to reconcile current estimates on the importance of terms of trade and suggest an intensive evaluation of the origins of terms-of-trade movements by policymakers before any intervention. / Thesis (PhD) — Boston College, 2024. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.