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Title: Terms of Trade Shocks in an Intertemporal Model: Should We Worry about the Dutch Disease or Excessive Borrowing?

Author(s): Karlygash Kuralbayeva and David Vines

Publication Date: October 2006

Keyword(s): capital inflows, Dutch disease, external debt, optimizing models, overborrowing and real exchange rate

Programme Area(s): International Macroeconomics

Abstract: This paper analyzes the impact of terms of trade and risk-premium shocks on a small open economy in an intertemporal, Dutch disease model, with international capital mobility. It is shown that when the economy experiences a permanent improvement in the terms of trade, the Dutch disease effect (real exchange rate appreciation) goes away in the new steady state, while the economy experiences de-industrialization even stronger than in the short-run. Second, a permanent improvement in the terms of trade coupled with a permanent reduction in the risk-premium leads to pro-industrialization and a real exchange rate appreciation. The mechanism behind appreciation of the real exchange rate in the long-run is different from the Dutch disease story. It occurs because reduction in the risk-premium reduces the costs of the production in the economy, and because (non-oil) traded sector benefits more from cheaper capital than the non-traded sector. The economy also accumulates more debt in response to these two shocks in the long-run.

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Bibliographic Reference

Kuralbayeva, K and Vines, D. 2006. 'Terms of Trade Shocks in an Intertemporal Model: Should We Worry about the Dutch Disease or Excessive Borrowing?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5857