Back Matter
• 1 https://isni.org/isni/0000000404811396, International Monetary Fund

### APPENDIX I

#### I. The Decrease in Output Volatility from the Addition of an Extra Industry

Suppose a country has N industries that produce output {yl, y2,…, yN} and are subject independent and identical output shocks with variance, σ2. Define Y as the economy’s aggregate output (i.e. Y = yl + y2 + … + yN). Let us measure how well diversified the economy is by the variance of average industry output, $\frac{Y}{N}$. Since the variance of a sum of N independent variables is the sum of the variances, the variance of average industry output, V, is therefore $V=\frac{{\sigma }^{2}}{N}$. Taking logs of both sides and differentiating yields: $\frac{\frac{dV}{V}}{dN}=-\frac{1}{N}$. Thus, the percentage decrease in volatility stemming from the addition of an extra industry falls dramatically as the number of industries increases.

### APPENDIX II

#### II. The Welfare Gains from Reducing Consumption Variability

Let us compute the welfare gains from reducing consumption by postulating that households receive an uncertain consumption stream {c}, which has an expected value equal to C. We then ask what amount of money, m, households would prepared to pay so that that utility from receiving C-m with certainty is equal to the expected utility from the uncertain consumption stream c. That is, we would like to determine the value of m for which U(Cm) = E[U(c)]. A second degree Taylor series expansion of U(c) around C yields:

$\begin{array}{ccc}U\left(c\right)\approx U\left(c\right)-U\prime \left(C\right)\left(c-C\right)+\frac{1}{2}U″\left(C\right){\left(c-C\right)}^{2}.& \phantom{\rule{7.0em}{0ex}}& \left(1\right)\end{array}$

Taking expectations of both sides of this equation and using the fact that C = E[c] yields

$\begin{array}{ccc}U\left(c\right)\approx U\left(c\right)-U\prime \left(C\right)\left(c-C\right)+\frac{1}{2}U″\left(C\right){\left(c-C\right)}^{2}.& \phantom{\rule{7.0em}{0ex}}& \left(1\right)\end{array}$

Since U(Cm) – U(C) is approximately equal to −mU’(C), we have the result that$-mU\prime \left(C\right)\approx \frac{U″\left(C\right){\sigma }_{c}^{2}}{2}$. Define R as the relative coefficient of risk aversion,$-\frac{CU″\left(C\right)}{U\prime \left(C\right)}$. Re-arranging terms, we see that,

$\begin{array}{ccc}\frac{m}{C}=\frac{R}{2}{\left[\frac{{\sigma }_{c}}{C}\right]}^{2}.& \phantom{\rule{7.0em}{0ex}}& \left(3\right)\end{array}$

Equation (3) tells us how what fraction of expected consumption households would be willing to forego to completely eliminate consumption variability. As an example, suppose your outlook is such that there is a 50 percent chance you will have consumption of $25,000 next year and a 50 percent chance that your consumption will be$75,000. How much would you be willing to pay eliminate this uncertainty? In this case, C equals $50,000 and , you would be prepared to pay 25 percent of your expected consumption, or$12,500 to eliminate this uncertainty. In other words, you should be indifferent between the aforementioned gamble or being able to consume $37,000 with complete certainty. Notice a key feature of equation (3): the welfare cost from consumption variability increases at an accelerating rate as $\frac{{\sigma }_{c}}{C}$, the coefficient of variation of consumption, rises. If household X’s coefficient of variation is twice as large as household Y’s, then the welfare cost of consumption variability for household X will be four times as large as for household Y. If household X’s coefficient of variation is four times as large as household Y’s, then welfare cost of consumption variability for household X will be 16 times as large as for household Y. This suggests that the cost of consumption variability may be quite low even for “somewhat unstable” economies but extremely high “very unstable” economies. In practice, estimating equation (3) is confounded by at least four major problems. First, although our ultimate interest is in estimating the gains from reducing the variability of household consumption, we only have data on aggregate consumption. Data on aggregate consumption is likely to be more “smooth” than data on household consumption since idiosyncratic shocks to household consumption will be averaged away. As an example, consider an economy that consists of two households, household A and household B. Suppose that 50 percent of the time, household A earns$500 a week while household B earns $1,500 a week. The other 50 percent of the time, when household A earns$1,500 a week, household B earns only $500. Aggregate consumption in this economy will always be$2,000 a week. If we calculated σc using aggregate consumption data, it would be equal to zero. However, if household A and B can not pool consumption (so that A lends to B when A is relatively rich and A borrows from B when B is relatively rich), then the true value of σc is equal to $\sqrt{0.5{\left(15000-1000\right)}^{2}+0.5{\left(500-1000\right)}^{2}}=500$. Thus, equation (3) can only be used to estimate the welfare gain from eliminating aggregate consumption variability. The actual welfare gain from eliminating household consumption variability may be much larger than the gain from just eliminating household consumption variability.

The second major problem stems from measurement error. Although data on aggregate consumption for all Caribbean economies is available from the national accounts, the data are not entirely reliable. Thus, it is likely that some of the observed variability in aggregate consumption is due to measurement error. This problem will lead us to overstate actual consumption variability.

Third, the economics literature has failed to deliver a consistent measure of the R, the coefficient of relative risk aversion. Empirical estimates of R vary substantially. Most estimates fall in the range of 1 to 6.51 Given the unitary elasticity between m and R, this implies an equally wide margin of error for the estimated value of $\frac{m}{C}$.

Fourth, and most importantly, the calculation of σc is very sensitive to what assumptions we make about the underlying stochastic path of consumption. In a seminal paper, Lucas estimated the welfare gain from completely eliminating aggregate consumption volatility in the United States.52 Crucial to his results was the assumption that that per capita consumption follows a trend-stationary path. Lucas found that the welfare gain from eliminate aggregate consumption in the United States is less than one tenth of a percentage point of expected consumption. In contrast, many subsequent papers have assumed that consumption is nonstationary, reflecting Hall’s (1978) theoretical result that household optimization should lead to consumption paths that follow random walks.53 The assumption of nonstationary invariably leads to much larger estimates of consumption variability since the standard deviation of consumption increases as time passes.

To see this, consider the following thought experiment involving a nonstationary consumption path. Initially, you are given $100 of consumption. Every week, a coin is flipped. If the coin turns up heads, you receive an extra$5 dollars of consumption but if the coin turn up tails, you lose $5 of consumption The following week, a new coin is flipped and$5 is added to whatever amount of consumption you had the previous week. Thus, in the first week you will end up with $95 with 50 percent probability or$105 with 50 percent probability. In the second week, however, you will end up with $90 with 25 percent probability,$100 with 50 percent probability, or $110 with 25 probability. The standard deviation of consumption is$5 in the first week but rises to over \$7 the following week, and so on.

In some sense, the debate about whether aggregate consumption data contains a unit root (most research suggests that it does not) misses the point. It really does not matter what one thinks of the statistical properties of consumption time series data per se. What matters is that one be precise in asking the correct question. It is this paper’s contention that the appropriate question is: In hindsight, what fraction of aggregate consumption were Caribbean countries willing to forgo every year in order to have the same average consumption growth rate as they actually had but with no variance in the growth rate? In other words, if Trinidad and Tobago had a average consumption growth rate of 1.22 percent between 1960 and 1997 with a standard deviation of 10.4 percent, what fraction of annual consumption were the people of Trinidad and Tobago be willing to forsake every year to have an average growth rate of 1.22 percent but with zero variance?

By focusing on consumption paths in which deviations from the trend do not affect the trend, we necessarily assume that consumption paths are trend-stationary. From this standpoint, it is not surprising that Auffret and Mora-Báez (2001) find enormous welfare losses from consumption variability in the Caribbean. By moving away from a framework in which consumption is stationary, they end up asking an important, but a somewhat irrelevant question, namely: What fraction of aggregate consumption were Caribbean countries willing to forgo in order to avoid the possibility of experiencing a prolonged period of unfavorable shocks that would have left consumption levels below those of say, sub-Saharan Africa? Not surprisingly, Auffret and Mora-Báez determine that the answer is “a lot.”

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The first two authors are in the IMF Asia and Pacific Department and Western Hemisphere Department, respectively, and the third author is currently at the InterAmerican Development Bank. They were all in the IMF Western Hemisphere Department when the paper was first drafted. They would like to thank, in particular, colleagues in the IMF Caribbean I and II Divisions for useful discussions and suggestions.

Obstfeld and Rogoff (1996), for instance, develop a model of a small open economy with a constant rate of productivity growth that exceeds world productivity growth. In their model, under a set of plausible parameters, after an initial period of heavy borrowing, the economy runs a steady trade surplus equal to 45 percent of GDP. Fernandez de Cordoba and Kehoe (2000) calibrate an intertemporal model to determine how Spain’s current account should have evolved after its 1986 entry in the European Union. They find that the optimal response would have been to run a current account deficit of 60 percent of GDP, about 20 times greater than what was actually observed.

The slope coefficient was insignificant at the 5 percent level due to the low number of observations in the sample.

Since the European Union (EU) grants preferential treatment to traditional agricultural exports such as sugar and bananas, this has reduced the incentive to diversify into new agricultural products.

Dominica’s agriculture sector, which is dominated by banana production, accounts for about 20 percent of GDP. Not surprisingly, Dominica has the highest standard deviation of per capita output growth of any country in the region.

Rodrik(1999).

In Japan, the function performed by social programs and income transfers was partly supplanted by business policies such as the practice of offering workers de facto life-time employment.

Hurricane Allen, for example, destroyed over 90 percent of the Windward Islands banana crop in the beginning of the 1980s (Grosmann, 1994; Itam et al., 2000).

The CARICOM treaty affirms that the member states should “undertake to promote a process of industrial development” that would “minimize product differentiation and achieve economies of large-scale production, consistent with the limitations of market size” in view of “the promotion of exports to markets both within and outside the Common Market.” At the regional level, several agreements have been signed with the objective of promoting industrialization. Among the most important is the Agreement on Harmonization of Fiscal Incentives to the Industry, which has the following objectives: (i) to promote investment in industry; (ii) to reduce competition among members; (iii) to rationalize the criteria for granting incentives by targeting projects with high domestic value added; and (iv) to reduce inequity among members. The main incentives were: (a) profit tax holiday; (b) tariff exemptions; (c) export allowance for extraregional exports after expiration of tax holiday; (d) dividend payments; (e) loss carry forward; and (f) depreciation allowance. Also important was the Industrial Allocation Scheme for the Organization of Eastern Caribbean States (OECS), which aims to organize the distribution of production equitably across OECS countries. This scheme never really worked: the arrangement for the region was undermined by political pressure in each country for more job creation at the local level.

Extraregional exports of manufactured goods and chemicals increased by 685 percent and 187 percent, respectively, during 1980–89, in spite of a decrease in total extraregional exports by 44 percent in the same period.

Among the most important was the Caribbean Basin Economic Recovery Act of 1983 (CBI) with the United States, and the Lomé Convention with Europe. The CBI—expanded in 2000 under the title of The Trade and Development Act—extends preferential tariff treatment (similar to NAFTA) to products such as textiles, wearing apparel, footwear, petroleum, handbags, luggage, and leather apparel. It adopted a duty-free and quota-free treatment for, among other items, certain textiles and wearing apparel articles assembled using inputs from the United States, certain handmade articles, and certain textile luggage. It also extended a duty-free treatment, but limited by quotas, to certain rum and certain apparel articles. The participation in the CBI is subject to periodic reviews that could include issues such as intellectual property rights, environment, and labor standards. The importance of the CBI is highlighted by the impending expiration of the Multifiber Agreement on January 1, 2005. The resulting increase in competition, as quotas are eliminated, makes the Caribbean geographic proximity to the U.S. market particularly important. The Lomé Convention defines the conditions and modalities of the cooperation between Europe and former colonies in Africa, the Caribbean, and the Pacific (also called the ACP group of countries). Starting in 1975 and expiring in 2000, the Convention provided duty-free access to almost all ACP exports to the European market. The successor agreement, signed in June 20000 in Cotonou, reaffirmed some European commitments to the ACP countries, although adjusted to comply with WTO rulings. The preparatory period will expire in 2007, and it is expected that there will be some profound changes in the way of doing business with EU. The Caribbean-Canada Agreement (CARIBCAN) grants duty-free entry to some products from the English speaking Caribbean with 60 percent of local content since 1986. It was updated in 1998 to include methanol, lubricating oils, etc.

The EU banana regime restricts non-ACP banana producers through a system of tariffs and quotas and guaranteed market access to ACP producers up to 850,000 tons.

For a critical view on the “banana dependency” in the Windwards Islands, see Welch (1994).

Pritchett (1999).

Barro (1997).

Net enrollment ratio is the ratio of the number of children of official school age (as defined by the education system) enrolled in school to the number of children of official school age in the population. Primary provides the basic elements of education at elementary or primary schools.

World Bank: A Caribbean Education Strategy. For example, the secondary school completion rate in Jamaica was 42 percent and in Trinidad and Tobago, 33 percent. Typically, secondary school completion rates average about 80 percent in OECD countries.

In other words, an extra year of schooling, on average, raises annual wages by 5.7 percent for males of African decent.

Coppin and Olsen (1998). Given the relatively low rate of return to Indian males, it is not surprising that Indian males averaged fewer years of schooling. The lower rate of return to education for Indians reflects the fact that the Indian population in Trinidad resides primarily in rural areas while the African population resides primarily in urban areas, chiefly in the country’s largest city, Port of Spain. Presumably, better education yields a low return if one is employed in the agricultural sector where higher education is not necessary for most jobs.

See Psacharopoulos (1994), for instance.

See Freeman (1999) for a good discussion of the social return to education in sub-Saharan Africa. Acemoglu and Angrist (1999) find that the social return to education in the United States is close to zero.

“Jamaicans” are classified as people born in Jamaica, even if they had U.S. citizenships at the time of the census.

There are, of course, benefits to Caribbean countries from outward migration. People who leave reduce the supply of labor back home, thus decreasing unemployment and the fiscal burden of social assistance. Furthermore, the large supply of Caribbean expatriots ensures that a steady stream of remittances flow back to the islands. In addition, there is much research that suggests that ethnic groups living outside their country of origin help create formal and informal networks that spur trade between the host country and the mother country. For instance, one recent study finds that the presence of ethnic Chinese networks in a host country increases bilateral trade between the host country and China by at least 150 percent [Rauch and Trindade (1999)].

Indeed, during the Mexican and Asian financial crises, FDI flows, unlike other capital flows, remained positive. Foreign firms were able to redirect sales from local markets to export markets. Furthermore, foreign firms benefited from the crisis-induced devaluations since this reduced the cost of labor in host countries (see Lipsey, 2001 for details).

Recent work suggests that developing countries would benefit by shifting their infrastructure budgets away from headline-grabbing new projects and focusing more on maintaining existing infrastructure. Hulten (1996), for example, finds that inadequate maintenance of existing infrastructure imposes a large growth penalty on developing countries. However, he finds no evidence that countries incur a growth penalty if they decrease spending on new infrastructure projects.

Guasch (2000).

See Grossman (1989) for example.

Transparency International Corruption Perception Index (2002).

De Soto (2010).

The World Bank (1996), for instance, estimates that Jamaica’s informal economy is about 30 percent of GDP.

This involves the Jamaica Digiport International teleport, which allows tenants to benefit from high quality and competitively priced telecommunications.

See Krugman and Venables (1995) for instance.

The Challenge of Diversification in the Caribbean
Author: Mr. A. Salehizadeh, Mr. Peter Berezin, and Mr. Elcior Santana