DARRIN DOWNES [*]
This study investigates the direction of causality between the money supply and reserve money for some selected Caribbean countries using recently developed techniques of causality tests. The findings suggest that neither money endogeneity nor money exogeneity can be generalized to all small, open economies. The causal patterns may differ according to whether the monetary arrangements of the countries follow either a fixed or flexible exchange rate regime. Moreover, this study highlights the fact that a mixed bag of policies must be implemented by respective central banks to maintain macroeconomic stability. (JEL E50)
In developed economies, monetary theorists assume a stable money multiplier relation, expressed as the ratio of an endogenous money supply and an exogenous monetary base. Under this proposition, the monetary authority exerts a high degree of control over the monetary base, and by predicting the value of the money multiplier, it manipulates the monetary base to achieve a desired level of the money supply. This theoretical view has been questioned for some time and has recently become the focal point of debate, especially among practitioners [Goodhart, 1984, 1994]. In light of this, Howells and Hussein  investigates whether broad money is endogenous in the G7 countries (the U.S. United Kingdom, France, Germany, Japan, Italy, and Canada). Their empirical findings reveal that it is endogenous in all cases, that is, there is unidirectional causality from loans to deposits.
In the context of small, open economies, not only is the stability of the money multiplier in question, but more fundamentally, it is argued that the monetary base is endogenous (see McClean [1981, 1985]). In recent studies, McClean [1997, 1998] examined the causal relationship between the narrow money supply (M1) and the monetary base for the small, open economy of Barbados. His empirics suggest that narrow money has a causal predominance over base money.
This study builds on the efforts of the previously mentioned authors. In particular, it extends the research of McClean [1997, 1998] by providing evidence of the direction of causality between the money supply and reserve money for 10 fixed exchange rates and three flexible exchange rates for small, open Caribbean economies. The aim here is to compare these findings with those of Howells and Hussein  on developed countries and to comment on the generalization of the endogeneity results to small, open economies. A Granger causality test, which is based on cointegration and error correction representations, is employed using a consistent set of quarterly...