ABSTRACT
This chapter proposes an approach to macroeconomic policy which equips the authorities in small open financially integrated economies (SOFIEs) to target the exchange rate by influencing the volumes of trade in goods and services to achieve equilibrium at target rate. It describes an economic model which incorporates the structural features of SOFIE, and examines how fiscal policy may be used to target the exchange rate. In 2013 Barbadian policymakers successfully defended the country’s exchange rate peg to the US dollar by making use of this framework to guide fiscal policy adjustment, in order to relieve pressure on foreign exchange market. The Central Bank of Barbados had a minimum reserve target of a sum equivalent to three months of imports, the amount the Bank judged adequate to reassure the foreign exchange market about the soundness of the peg. The use of fiscal tools is the SOFIE’s most assured strategy in response to external shocks, such as a loss of external competitiveness.
