model is able to generate a countercyclical trade balance and real interest rate, with the values of correlations quite similar to those in the OECS data. Under pro-cyclical fiscal policy (panel 3.a), net exports becomes even more countercyclical. Adding induced country risk-premium (panel 2) does not change the basic pattern of correlations, but makes interest rate more countercyclical, while reducing the negative co-movement between trade balance and GDP.

Lastly, Table 8 presents the cyclical properties of key variables with the real interest rate. An important finding in the OECS counties data was that real interest rates are strongly countercyclical with main macroeconomic aggregates. Table 8 shows that the model reproduces this result quite closely. In particular, in the benchmark scenario (panel 1.a), real interest rate commoves negatively with investment, consumption and employment. The correlation with net exports is positive. The signs of the correlations remain unchanged both under a pro-cyclical fiscal policy and with induced country-risk scenario. Also note that the correlation between interest rates and government expenditures is close to zero both in the data and in the model.

Overall, we show that the model does a good job in matching the properties of business cycles in the OECS countries. Several results can be emphasized from the model so far. First, procyclical fiscal policy curtails the effects of productivity shocks in the economy, and reduces the volatility of consumption and net exports. Second, if risk-premium responds to the changes in the economy’s fundamentals, the effects of productivity shocks on the economy are amplified through the working capital channel, and therefore the volatility of key macro aggregates rises. This amplification effect would disappear if there was no spillover from productivity to country riskpremium (��=0) or if there was no need for working capital (�=0).

We have also isolated the contribution of various shocks to the overall volatility in the economy re-computed volatilities and correlations in the model while sequentially eliminating shocks to productivity, government expenditures, and interest rate shocks (international interest rate and country risk-premium). The results are presented in panels b, c, and d of Tables 6, 7, 8.

Without productivity shocks (panels b of Table 6, 7, 8), volatilities of several variables are significantly reduced relative to the benchmark case with all shocks. For instance, GDP volatility declines from 3.72% when all shocks are present) to 1.81% when productivity shocks are switched off, implying that productivity shocks account for about 51% of GDP volatility in the Eastern Caribbean economies. Volatility of net exports also declines when productivity shocks are eliminated from the simulations, although the decline is more muted. Specifically, productivity shocks account for about 7% of volatility in next exports. In contrast, volatilities of investment, consumption, employment, all rise when productivity shocks are eliminated. Similarly, the negative correlation between trade balance and GDP, and interest rate and GDP become exaggerated without the productivity shocks. All together, these results suggest that these shocks are important in explaining business cycles in the OECS economies.

**<u>Table 8. Simulated and actual business cycles in the OECS countries: Co-movement with interest rate</u>**

||**Correlatio**<br>|**n of Interest ra**<br>|**te with**<br>|||
|---|---|---|---|---|---|
||Inv|Gov exp|Cons|TB/GDP|Employment|
|OECS data|-0.29|-0.04|-0.33|0.24|-0.36|

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