4: Global shocks: oil prices
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Overview
 Global shocks and responses
 Oil price
 World economic growth
 Real interest rates
 Indonesia’s “other” D.D.
 Philippine currency crisis
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The resource wealth paradox
 “Since the second world war it has become quite clear that rapid
economic growth is available to those countries with adequate
natural resources which make the effort to achieve it.”
 W.A. Lewis 1968, Some Aspects of Economic Development: ix
 “Incentives to create wealth sometimes get blunted by the ability to
extract wealth from the soil or the sea. Rich parents sometimes
spoil their kids; Mother Nature is no exception.”
 J. Sachs and A. Warner 2001: “The curse of natural resources”, Eur.
Econ. Rev.
 “You can’t build ships by selling fish”
 B.J. Habibie, Indonesian minister for science & technology (1997)
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The resource curse hypothesis
 Sachs and Warner: countries with abundant natural resource
wealth grow more slowly
 Dutch disease: non-resource tradable sectors don’t grow as fast
 NR-rich econs don’t invest in renewable assets (capital,
education)
 Returns to human capital investments are likely to be low

E.g. Thailand’s low secondary enrollment rates
 Resource wealth may promote inefficiency and corruption
 Commodity price instability may reduce investment efficiency
 Puzzle: why are major SE Asian countries exceptions to the
Sachs-Warner story?
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Reasons for the SE Asian difference?
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Model: resource exports and Dutch Disease
 Traded (T) and non-traded (N) goods in a ‘small’ economy
 Assume traded goods enter domestic market at (given) world price
Global demand (exports) or supply (imports) infinitely elastic
 Non-traded goods: domestic market clears; price is endogenous

 Assume 3 sectors:
T = Traditional exports and import-competing sectors
 N = non-traded services; demand is highly income-elastic
 Labor is mobile among all sectors

 Real exchange rate RER = pN/pT
= pN/EpT* , where pT* are world prices (in $) and E = Rp/$
 Ex. 1: nominal exch rate appreciation (fewer Rp per $)  real
appreciation, or a rise in RER.
 Ex. 2: Rise in pN also  real appreciation
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Salter-Swan diagram
Traded goods
A
u(T, N)
RER
Nontraded (services)
• All traded goods aggregated on vertical axis
• All non-traded goods on horizontal axis
• Cannot trade N goods, so eq’m at A: production = consumption
• RER = pN/pT that clears domestic markets and trade
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Resource movement effect of a boom
Traded
goods
T1
B
C
T0
A
RER1
RER0
Nontraded (services)
N 1 N0
• Resource boom moves PPF out in direction of T only
• Assume (for now) that demand for N remains constant at N0
• At initial prices (RER0), move to B: but excess demand for N
• Adjustment requires a real appreciation to RER1 , i.e. pN/pT rises
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Income effect of a boom
Traded
goods
B
RER2
C
D
A
Income exp. path
for RER0
RER0
Nontraded (services)
N 1 N0 N2
• The boom generates new income for consumers
• Assume demand for N is income-elastic (grows along inc. exp. path)
• At initial prices (RER0), move to D, but excess demand for N
• Adjustment requires another real appreciation toward RER2
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Summary: the story so far
 The ‘boom’ in one tradable sector (say, oil) has supply and demand side
effects on the rest of the economy
 Supply side: resources (e.g. labor) pulled in from other sectors, incl.
non-tradables
 To sustain N production equal to demand, their price must rise
 Demand side: boom creates new income, and some (all) is spent
back into economy.
 Spending on N raises their price
 Two sources of real exchange rate appreciation
 What do these price changes, and associated reallocation of productive
resources, mean for the rest of the economy?
 Implications for growth, econ. structure, income dist?
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Effect of the boom in the labor market
d
w2
c
a
LT1
0N
w1
LN1
w0
LN0 LM
LT0
L0
LM0
0T
• Measure N sector employment from 0N, T sector emp. from 0T
• Initial labor market equilibrium at (L0, w0) = full employment
• Resource boom increases jobs in resource sector, moves LT to LT1
and wage to w1
• Spending effect increases jobs in N to LN1, raises wage to w2.
? What happens to M sector employment (and thus output)?
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Resource boom and Dutch disease
 In an economy producing resources, manufactures and services, a
‘boom’ (discovery of new resources):
 Raises output of resource sector and reduces output of both other
sectors through competition for labor, which raises wages …
… and leads to excess demand for services, which produces a real
appreciation …
… which diminishes output gain in resources sector and further
reduces jobs and output in manufacturing.
 The spending of new income created by the boom:
 Raises demand for all goods, including services, which leads to a
further real appreciation and wage rise …
… which once again reduces jobs and output in manufacturing
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More on resource booms
 Sector described as ‘manufacturing’ could instead be
traded agriculture (hence ‘deagriculturalization’), or both
 Technical progress such as green revolution can also be a
source of a ‘boom’
 ‘Enclave’ sectors (e.g. oil) may have little or no factor
market impact -- but income (spending) effect may be very
large
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The OPEC oil price booms
 OPEC oil price rises (1973 and 1978-80) raised
Indonesia’s terms of trade with rest of world.
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The OPEC oil price booms
 Big income effects:
 Indon. GDP up by ~15% in OPEC I, and ~20% in OPEC II
Indonesia: Real per capita household
expenditures ($)
300
250
200
150
100
50
0
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982
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Indonesia’s “other” Dutch disease
 Big real exchange rate effects (domestic inflation):
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Indonesia’s “other” Dutch disease
 Big structural change effects… but a puzzle too
* Why did manufacturing output not decline as predicted?
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How Indonesia avoided Dutch disease
• Increased protection for industry
• Nominal devaluations to offset inflationary effects of real
appreciation: 1978, 1983, 1986
• Support for other tradable sectors, especially agriculture:
– Infrastructure investments -- irrigation, roads, market facilities
– Capital market investments -- rural credit
– Human capital investments in rural areas (health & nutrition, education)
– Agricultural R&D investments-- new rice research
– Land colonization (transmigration programs) to maintain labor
productivity
* These measures also reduced poverty and rural-urban
inequality-- and so built political support for Suharto
regime
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Indonesia: Central government expenditures
60.00
25.00
50.00
15.00
Development exp
30.00
10.00
Total exp (US Bn)
20.00
5.00
10.00
85
19
84
19
83
19
82
19
81
19
80
19
79
19
78
19
77
19
76
75
19
19
74
19
73
19
72
19
19
71
0.00
70
0.00
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Percent
40.00
Total exp ($US bn)
20.00
Source: Woo et al Table A12
(Development exp as % of total exp, total exp. in $US
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Indonesia: Components of gov't spending by sector
4.50
4.00
Industry subsidies
Education
3.50
Other agr & irrigation exp
Fertilizer subsidy
2.50
2.00
1.50
1.00
0.50
Source: Woo et al Table A12
85
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84
19
83
19
82
19
81
19
80
19
79
19
78
19
77
19
76
19
75
19
74
19
73
19
72
19
71
19
70
0.00
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$US bn
3.00
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Poverty in Indonesia During the Oil Booms
60
Percent of reference group population
Urban (1)
50
Urban (2)
Rural (1)
40
Rural (2)
30
20
10
0
1976
1978
1980
1984
1987
(1): Biro Pusat Statistik (2): V.V.H. Rao, APEL
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Per capita household expenditure in developing oil exporters
(1974 = 100)
250
Algeria
200
Indonesia
Venezuela
150
100
50
Source: WDI
90
19
88
19
86
19
84
19
82
19
80
19
78
19
76
19
74
19
72
19
19
70
0
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Policy implications of Dutch disease
 If the ‘boom’ is permanent, change in economic structure
should not present a policy dilemma
 But for a temporary change, possible problems:
 If structural change is costly (transactions costs)
 If some sectors or industries suffer irreversible changes (e.g. go out of
existence)
 Moreover, deindustrialization could be a problem:
 If industry sectors exhibit positive externalities, e.g. from increasing returns
to scale, or learning by doing, or inter-industry productivity spillovers
 Foreign exchange windfalls can be ‘sterilized’ by saving
them as foreign assets rather than spending them in
domestic economy
 But political costs of this strategy
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Other examples of Dutch Disease in SE Asia
 Your thoughts?
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