1. 4: Global shocks: oil prices 0

2. Overview Global shocks and responses Oil price World economic growth Real interest rates Indonesia’s “other” D.D. Philippine currency crisis 1

3. 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) 2

4. 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? 3

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6. Reasons for the SE Asian difference? 5

7. 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 = p N /p T = p N /Ep T *, where p T * 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 p N also  real appreciation 6

8. Salter-Swan diagram 7 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 = p N /p T that clears domestic markets and trade u(T, N)

9. Resource movement effect of a boom 8 Traded goods Nontraded (services) RER 0 A B Resource boom moves PPF out in direction of T only Assume (for now) that demand for N remains constant at N 0 At initial prices (RER 0 ), move to B: but excess demand for N Adjustment requires a real appreciation to RER 1, i.e. p N /p T rises RER 1 C N 1 N 0 T1T0T1T0

10. Income effect of a boom 9 Traded goods Nontraded (services) RER 0 A B The boom generates new income for consumers Assume demand for N is income-elastic (grows along inc. exp. path) At initial prices (RER 0 ), move to D, but excess demand for N Adjustment requires another real appreciation toward RER 2 C Income exp. path for RER 0 RER 2 D N 1 N 0 N 2

11. 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? 10

12. Effect of the boom in the labor market 11 LN0LN0 LT0LT0 0 N L 0 L M 0 0 T w0w0 LMLM LN1LN1 LT1LT1 w1w1 w2w2 Measure N sector employment from 0 N, T sector emp. from 0 T Initial labor market equilibrium at (L 0, w 0 ) = full employment Resource boom increases jobs in resource sector, moves L T to L T 1 and wage to w 1 Spending effect increases jobs in N to L N 1, raises wage to w 2. ? What happens to M sector employment (and thus output)? a c d

13. 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 12

14. 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 13

15. The OPEC oil price booms OPEC oil price rises (1973 and 1978-80) raised Indonesia’s terms of trade with rest of world. 14

16. The OPEC oil price booms Big income effects: Indon. GDP up by ~15% in OPEC I, and ~20% in OPEC II 15

17. Indonesia’s “other” Dutch disease B ig real exchange rate effects (domestic inflation): 16

18. Indonesia’s “other” Dutch disease Big structural change effects… but a puzzle too 17 * Why did manufacturing output not decline as predicted?

19. 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 18

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24. 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 23

25. Other examples of Dutch Disease in SE Asia Your thoughts? 24