Does Demand Volatility Lower Growth and Raise Inflation? Evidence from the Caribbean

The paper investigates asymmetry in the allocation of aggregate demand shocks between real output growth and price inflation over the business cycle in a sample of fifteen Caribbean countries. In most countries, the evidence indicates the existence of a kinked supply curve, which implies that positive demand shocks feed predominantly into prices while negative demand shocks mainly affect output. This suggests that the high variability of aggregate demand in Caribbean countries, frequently exposed to shocks, tends to create an upward bias on inflation and a downward bias on real output growth, on average, over time. The analysis highlights the benefits of eliminating structural rigidities responsible for the kinked nature of the supply curve, and points to the dangers of pro-cyclical macroeconomic policies.