4: Global shocks: oil prices Overview Global shocks and responses  Oil price  World economic growth  Real interest rates Indonesia’s “other” D.D Philippine currency crisis 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) 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? Reasons for the SE Asian difference? 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 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 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 Traded goods T1 B C A T0 RER1 RER0 Nontraded (services) N1 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 Traded goods B RER2 C D A Income exp path for RER0 RER0 Nontraded (services) N N0 N • 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 10 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 these price changes, and associated reallocation of productive resources, mean for the rest of the economy?  Implications for growth, econ structure, income dist? 11 d w2 c a LT1 0N w1 LN 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)? 12 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 13 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 14 The OPEC oil price booms OPEC oil price rises (1973 and 1978-80) raised Indonesia’s terms of trade with rest of world 15 The OPEC oil price booms Big income effects:  Indon GDP up by ~15% in OPEC I, and ~20% in OPEC II 16 Indonesia’s “other” Dutch disease Big real exchange rate effects (domestic inflation): 17 Indonesia’s “other” Dutch disease Big structural change effects… but a puzzle too * Why did manufacturing output not decline as predicted? 18 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 19 Indonesia: Central government expenditures 60.00 25.00 50.00 20.00 40.00 15.00 30.00 Percent 20.00 Development exp Total exp (US Bn) 10.00 Total exp ($ 5.00 10.00 0.00 0.00 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Source: Woo et al Table A12 (Development exp as % of total exp, total exp in $US 20 ... 20.00 40 .00 15.00 30.00 Percent 20.00 Development exp Total exp (US Bn) 10.00 Total exp ($ 5.00 10.00 0.00 0.00 1970 1971 1972 1973 19 74 1975 1976 1977 1978 1979 1980 1981 1982 1983 19 84 1985... may reduce investment efficiency Puzzle: why are major SE Asian countries exceptions to the Sachs-Warner story? Reasons for the SE Asian difference? Model: resource exports and Dutch Disease... oil) may have little or no factor market impact but income (spending) effect may be very large 14 The OPEC oil price booms OPEC oil price rises (1973 and 1978-80) raised Indonesia’s terms of