In the absence of interest rate shocks, the cyclical properties of the key variables are also affected: the co-movement between GDP and consumption, investment and employment all increase above their data counterparts; trade balance becomes less countercyclical than in the data; and of course, the negative correlation between the interest rate and GDP, consumption, and investment disappears. We interpret this result as supportive of the importance of interest rate shocks in explaining the OECS business cycles.

The changes in volatilities and correlations are even more pronounced when we consider the scenario with induced country risk-premium. This case is summarized in panels 2.d) and 4.d) of Tables 6, 7, 8. Eliminating interest rate shocks when risk-premium is determined by domestic fundamentals leads to a 49% reduction in GDP volatility. Again, the majority of this reduction is accounted for by eliminating the shocks to risk-premium. Similarly, without interest rate shocks, consumption volatility in the OECS countries would decline by 21%, employment volatility by 33% and investment volatility by 59%.

Notice that the volatility of GDP declines when either productivity or interest rate shocks are eliminated from the model. In contrast, the volatilities of consumption, investment and employment rise when productivity shocks are absent from the model, while those volatilities decline in the scenario without interest rate shocks. The differences in the behavior of consumption, investment and employment in the two scenarios can be understood through the lens of agents’ risk-sharing opportunities in the model. Consider, first, a productivity shock. In response to such a shock, households and firms can borrow/lend in the international markets at a given interest rate, which allows them to smooth out the effects of the shock. The shocks to interest rate are harder to smooth out since they directly affect the cost of borrowing for working capital, and no other mechanisms for risk-sharing are available to the agents. As a result, these shocks make OECS economies more volatile.

We can quantify the importance of the financial channel by considering the case of the model with a smaller value for parameter that determines the size of the working capital requirement – parameter �. Table 9 presents the results for volatilities and correlations in the case where only 50% of the labor cost has to be paid in advance (�=0.5); and the case in which no labor cost has to be paid in advance (�=0). In both cases we keep all other parameters unchanged at their benchmark values given in Table 5. To quantify how the business cycle properties change with �, in Table 9 we report volatilities of the key aggregates relative to their respective volatilities under the benchmark model scenario with �=1.

Let’s focus on the model scenario with independent fiscal policy presented in panel 1 of Table 9 (the results are similar with pro-cyclical fiscal policy). When �=1 the model generated volatility of GDP and investment that was very similar to that found in the OECS data. Similarly, it was able to replicate the negative co-movement between GDP and trade balance, and between GDP and the interest rate. When the working capital parameter � is reduced to 0, the volatility of GDP, consumption, employment and government spending, all decline significantly. For instance, GDP volatility is reduced by 14%, while that of consumption by 24%, and employment – by 30%. Similarly, the correlation coefficient between output and interest rate turns from being large and negative to being positive. The same is true for the correlation between consumption and interest 26