The black-market exchange rate and currency substitution in a small open economy: An empirical analysis of Barbados

Abstract

Empirical evidence of the existence of currency substitution in Barbados between 1973 and 1986 is provided. Within an environment of trade restriction, foreign exchange control, and a black market for foreign exchange, the demand for money is estimated using the black-market premium as one of the independent variables. This variable as a proxy measures the opportunity cost of holding domestic money vis-à-vis foreign money, and its statistical significance indicates the existence of currency substitution in the demand for only M1, which could render stabilization policies ineffective.