the Eastern Caribbean economies and other parts of the world. In doing so, we explore the impact of terms of trade volatility, fiscal policy (pro) cyclicality, and financial development for a sample of 175 countries over the period 1980-2010. By considering the effects of the interaction between terms of trade volatility and fiscal pro-cyclicality we are able to gauge (i) whether fiscal procyclicality exacerbates the negative growth effect of terms of trade volatility; and (ii) whether the mediating role of fiscal policy cyclicality is particularly pronounced in the OECS as compared to other countries. This is an important policy discussion for a region that adopts a strong peg against the US dollar since this arrangement limits considerably their ability to respond to shocks. In addition, the interaction between terms of trade volatility, pro-cyclicality and financial development will generate evidence as to whether a counter-cyclical fiscal policy stance and further financial development can mitigate the adverse growth effects of terms of trade volatility in the OECS region.

The paper is organized as follows. After this Introduction, section 2 discusses the econometric approach, the methodology, and the data used in the analysis. Section 3 presents a brief review of the literature on terms of trade volatility, government spending cyclicality, and financial development can affect economic growth. Section 4 describes the empirical findings while section 5 discusses what should be the direction of policy for a stronger financial sector; what the options are for a more counter-cyclical fiscal policy in the presence of a pegged exchange rate regime; and how policy makers in the region can be better equipped to deal with the effects of terms of trade volatility and mitigate its impacts on growth.

# **2. Econometric Model, Methodology, and Data**

The main objective of this paper is to test the hypotheses that: (i) an increase in volatility results in lower GDP growth; (ii) the negative impact of volatility on growth is more pronounced in less financially developed countries; and (iii) in countries where fiscal policy is more pro-cyclical.

Testing the above hypotheses requires cross-country time-series (panel) data on GDP per capita, financial development, and government spending. These data are available from the Penn World Tables and the World Development Indicators.

The econometric model for testing hypotheses (i)-(iii) is:

- (1) Growthit = ai + bt + αVolatilityit + β(Volatilityit*FDi) + γ(Volatilityit*Procyclicalityi) + φlnGDPit-1 + eit

where _Growth_ is the change in the natural logarithm of real GDP per capita in country i between period t and t-1. _Volatility_ is the country-specific standard deviation of external economic shocks. Following Rodrik (1998), we will use the standard deviation of countries' terms of trade as the measure of externally induced economic volatility. _FD_ is a measure of financial development. Following the finance literature, our main measure of financial development is the GDP share of domestic credit to the private sector. In order to avoid reverse causality bias (i.e. growth affects financial development), the _FD_ measure will be used in the econometric model at the beginning of the sample period. Further, the paper will present estimates where _FD_ is instrumented with legal origin.<sup>3</sup>

> 3 The law and finance literature, see, for example, La Porta et al. (1998), has documented that countries' legal origin is an important determinant of cross-country differences in financial development. La Porta et al. argued that common law ensures a greater protection of private property (relative to civil law). Protection of private property is paramount for investment and the development

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