DP8086 Absorbing A Windfall of Foreign Exchange: Dutch disease dynamics

Author(s): Frederick van der Ploeg, Anthony Venables
Publication Date: October 2010
Keyword(s): absorption constraints, absorptive capacity, aid, Dutch disease, natural resources, windfall
JEL(s): 011, E21, E22, F10, F35, H63, O16, Q33
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8086

The response of an economy to a windfall of foreign exchange (be it aid or natural resource revenues) is often constrained by absorptive capacity. We provide a micro-founded analysis of absorption constraints, based on the idea that expanding the economy?s capital stock (in aggregate or sectorally) requires non-traded inputs, the supply of which is constrained by the initial capital stock. Given this constraint, the economy will manifest ?Dutch disease? symptoms, although many of them are temporary. On impact there is sharp appreciation of the real exchange rate, which will then depreciate back to its equilibrium level. In contrast to the permanent income hypothesis, real consumption jumps part of the way to its new long-run level, and then continues to rise. Depending on the capital-intensity of the investments needed for the adjustment, the economy may run a current account deficit or surplus in early years