Business cycles and the optimum exchange rate of a small open economy : the case of Bahrain
This thesis utilizes time series techniques to investigate Bahraini business cycles and the optimality of Bahrain's exchange rate arrangements. To do so it is necessary to disaggregate the annual series of GDP, non-oil GDP, government expenditure, GDP deflator and non-oil GDP deflator into quarterly observations. The results on the business cycles show that the series of GDP, non-oil GDP and oil GDP have little persistence. Additionally, the results show that government expenditure is the only macro variable Granger causing non-oil business cycles and that the existing exchange rate regime does not Granger cause non-oil GDP. The survey on the optimum exchange rate literature shows that several of the theoretical exchange rate models are based on very strong assumptions that deter us from using them. The optimality of the Bahrain Dinar (BD) exchange rate regime is tested using an extended Horne-Martin approach. Further tests are carried out to examine the effects of the post-Bretton Woods exchange rate arrangements for the BD on the conduct of interest rate policy and domestic inflation. The results reveal that domestic interest rate policy is divorced from domestic fundamentals and that the post-Bretton Woods exchange rate arrangements did not inhibit domestic inflation from converging to the world average inflation rate. These results, plus those of chapter three, cast serious doubt on the optimality of the BD exchange rate arrangements. Indeed, the optimality test rejects the existing regime and shows that Bahrain cannot have an optimum peg regime. Thus the authorities have the option of floating the BD. However, the authorities may opt for a second best peg arrangement, but at the expense of obtaining counter intuitive results.