Does Demand Volatility Lower Growth and Raise Inflation? Evidence from the Caribbean

IMF Working Papers, April 29, 2014

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Investigates asymmetry in the allocation of aggregate demand shocks between real output growth and price inflation over the business cycle in a sample of fifteen Caribbean countries.
In most countries, evidence indicates the existence of structural constraints, implying that positive demand shocks feed predominantly into prices while negative demand shocks mainly affect output.
High variability of aggregate demand in Caribbean countries, frequently exposed to shocks that are exacerbated by pro-cyclical policy stance, tends to create an upward bias on inflation and a downward bias on real output growth, on average, over time.
Analysis highlights the benefits of eliminating structural rigidities responsible for asymmetric real and inflationary effects and points to the dangers of procyclical macroeconomic policies that exacerbate the adverse effects of demand variability.

Sample: fifteen Caribbean countries.
Asymmetric allocation of aggregate demand shocks:
- Positive demand shocks → predominantly increase prices (price inflation).
- Negative demand shocks → mainly reduce output (output contraction).
Consequences of demand variability in the region:
- Upward bias on inflation over time.
- Downward bias on real output growth over time.
Role of policy stance:
- Pro-cyclical macroeconomic policies frequently exacerbate shocks and their asymmetric effects.

Eliminate structural rigidities that cause asymmetric real and inflationary effects.
Avoid pro-cyclical macroeconomic policies that exacerbate the adverse effects of demand variability.
Increase price flexibility to reduce the transmission of positive demand shocks into inflation.
Address policy frameworks and institutional constraints that amplify output contractions in response to negative demand shocks.

Subject: Exchange rate arrangements; Exchange rates; Foreign exchange; Inflation; Prices; Production; Production growth; Sticky prices.
Keywords: Caribbean; Demand Shocks Asymmetric Effects Contractionary and Inflationary Biases; demand variability; energy price; Exchange rate arrangements; Exchange rates; expansionary demand shock; Inflation; inflation bias; inflation to expansionary demand shocks; output contraction; output growth; price flexibility; price inflation; price inflation to expansionary demand shocks; price rigidity; price uncertainty; product price; Production growth; real growth; Sticky prices; trade balance; trend inflation; WP.