4: Global shocks: oil prices

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Overview

Global shocks and responsesOil priceWorld economic growthReal 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 slowlyDutch disease: non-resource tradable sectors don’t grow

as fastNR-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 ratesResource wealth may promote inefficiency and corruptionCommodity price instability may reduce investment

efficiencyPuzzle: 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’ economyAssume traded goods enter domestic market at (given) world price

Global demand (exports) or supply (imports) infinitely elasticNon-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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Traded goods

Nontraded (services)

RER

A

• 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

u(T, N)

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Traded goods

Nontraded (services)

RER0

A

B

• 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

RER1

C

N1 N0

T1

T0

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Traded goods

Nontraded (services)

RER0

A

B

• 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

C

Income exp. pathfor RER0

RER2

D

N1 N0 N2

Summary: the story so farThe ‘boom’ in one tradable sector (say, oil) has supply and

demand side effects on the rest of the economySupply side: resources (e.g. labor) pulled in from other

sectors, incl. non-tradables To sustain N production equal to demand, their price must

riseDemand 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 appreciationWhat 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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LN0LT

0

0N L0 LM0 0T

w0

LM

LN1

LT1

w1

w2

• 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 LT

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and wage to w1 • Spending effect increases jobs in N to LN

1, raises wage to w2. ? What happens to M sector employment (and thus output)?

a

c

d

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

manufacturing13

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 boomsOPEC 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 boomsBig income effects:

Indon. GDP up by ~15% in OPEC I, and ~20% in OPEC II

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Indonesia’s “other” Dutch diseaseBig real exchange rate effects (domestic inflation):

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Indonesia’s “other” Dutch diseaseBig structural change effects… but a puzzle too

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* Why did manufacturing output not decline as predicted?

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

0.00

10.00

20.00

30.00

40.00

50.00

60.00

1970197119721973197419751976197719781979198019811982198319841985Source: Woo et al Table A12

(Development exp as % of total exp, total exp. in $US

Percent

0.00

5.00

10.00

15.00

20.00

25.00

Total exp ($US bn)

Development exp

Total exp (US Bn)

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Indonesia: Components of gov't spending by sector

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

1970197119721973197419751976197719781979198019811982198319841985

Source: Woo et al Table A12

$US bn

Industry subsidies

Education

Other agr & irrigation exp

Fertilizer subsidy

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Poverty in Indonesia During the Oil Booms

0

10

20

30

40

50

60

1976 1978 1980 1984 1987

(1): Biro Pusat Statistik (2): V.V.H. Rao, APEL

Percent of reference group population

Urban (1)

Urban (2)

Rural (1)

Rural (2)

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Per capita household expenditure in developing oil exporters (1974 = 100)

0

50

100

150

200

250

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990

Source: WDI

Algeria

Indonesia

Venezuela

Policy implications of Dutch diseaseIf the ‘boom’ is permanent, change in economic

structure should not present a policy dilemmaBut 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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