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Chapter 03 News Analysis: Dutch Disease

Economies that rely heavily on exploitation and export of natural resources may experience the surprisingly damaging effect of large inflows of capital. In the 1960s, a discovery of large natural gas deposits in the North Sea and subsequent Dutch ownership of natural gas resources pushed up the country’s real exchange rate and ultimately caused a decline of the Netherlands’ manufacturing sector in the 1970s. The term Dutch Disease was coined in reference to the negative effect of an increase in revenues in the booming resource sector.

How can too much of a good thing be bad? Read the article in the scroll box and then answer the questions that follow.

UNDERSTANDING THE “DUTCH DISEASE,” BY THE APLIA ECONOMICS CONTENT TEAM

How does an increase in revenues in the booming sector reduce incentives for engaging in activities in the nonbooming tradable sector? It all begins with a rapid increase in the world demand for natural resources such as oil and gas. Rising revenues from natural resources increase the demand for labor in the booming sector. This “resource movement effect” causes a shift in production from the lagging sector to the booming sector. At the same time, the extra revenue pouring from the booming sector results in the “spending effect” in the market for nontraded goods by pushing up demand (and, thus, the price) of nontraded goods. The rising demand for labor in the nontradable sector also attracts labor from the lagging sector, but prices of the traded goods in the lagging sector are set internationally and cannot change.
As a result of a higher demand for natural resources, the country experiences an inflow of the foreign currency, which causes the real exchange rate to increase and the nation’s currency to appreciate. Consequently, the nation’s exports become more expensive for other countries to buy. This further discourages investment in the nonbooming tradable sector, while investment in the booming sector continues to rise. Eventually, technological growth in the nonbooming tradable sector slows down relative to other countries, and the sector loses its competitiveness.

Brazil, Chile, Peru, Russia, and Venezuela all exhibit symptoms of the Dutch Disease. Chile, Peru, and Venezuela rely on raw materials for more than three-quarters of their total exports. In Russia, oil and gas make up two-thirds of exports, and the country’s rapid economic growth during more than a decade was mainly due to large increases in oil prices. Moreover, governments in these countries have grown more reliant on raw materials for their tax revenues.

The Dutch Disease, however, is not inevitable. The principle of comparative advantage suggests that commodity production can be beneficial to an economy. For example, the rise in world prices for Latin America’s commodities are estimated to account for over one-third of the region’s growth over the past decade. The disease develops under certain conditions: (1) when there is a close relationship between the value of a country’s currency and the price of its major export, (2) when the production structure of the economy and its exports are weakly diversified, and (3) when high industrial and manufacturing costs are exacerbated by the volatility in the price of natural resources.

Broadly, commodity-exporting countries could use two types of policies to minimize the effects of the Dutch Disease. The first is aimed at managing the wealth optimally in the long term by encouraging a high rate of saving and investment during the “boom” period. By investing the proceeds of exhaustible resources in human or physical capital, a country can avoid running down the stock of real wealth over time. This type of policy includes stabilization policies and sovereign wealth funds as well as trade liberalization policies that counteract excessive exchange rate appreciation.

A second type of policy is aimed at improving productivity and increasing competitiveness by investing in basic research and development. The key is not to grant subsidies and protection but rather to create a healthy business environment that facilitates the discovery of profitable investment opportunities and ensures that markets remain open and competitive. In many of today’s high-income countries such as Australia, Canada, Scandinavian countries, and the United States, natural resources provided the original basis of growth, after which they diversified into resource-based manufacturing and eventually into other, more knowledge-intensive industries.

According to the article, which of the following statements about the Dutch Disease are correct? Check all that apply.

a) As soon as a country’s resource revenues begin to rise, the Dutch Disease is imminent.

b) When a country’s currency appreciates, its manufacturing sector quickly gains competitiveness.

c) Currency appreciation makes the nonbooming tradable sector less attractive to the workforce, which turns to the nontrade sector, like services.

d) Increased demand for nontraded goods increases prices in the nontraded goods sector, which boosts the real exchange rate.

According to the article, which of the following describe the symptoms of the Dutch Disease? Check all that apply.

a) Investment in research to develop new technologies

b) Redistribution of the revenues from the resource sector to the manufacturing sector

c) Short-run economic decline followed by long-run, sustained economic growth

d) High industrial costs exacerbated by volatile resource prices

According to the article, which of the following statements about the Dutch Disease are correct? Check all that apply.

a) The Dutch Disease can be cured by allowing manufacturing jobs to move freely to other countries.

b) Increased demand for nontraded goods increases prices in the nontraded goods sector, which boosts the real exchange rate.

c) The Dutch Disease can be prevented if the government encourages a high rate of saving and invests the proceeds of exhaustible resources in human or physical capital.

d) Currency appreciation makes the nonbooming tradable sector less attractive to the workforce, which turns to the nontrade sector, like services.

Explanation:
The Dutch Disease causes currency appreciation and reduced competitiveness of the manufacturing sector. As a result, manufacturing jobs move to other countries. Well-governed countries manage to protect their economies from the Dutch Disease by implementing sound monetary policy, as well as using natural endowments to make key industries more efficient and productive, in part by utilizing innovations elsewhere in the economy. For example, Australia receives more income from intellectual property associated with the mining industry than it does from its mine exports.

Which of the following is a characteristic of the economic model used to explain the Dutch Disease?

a) The economy has the nontraded goods sector, which is booming, and two lagging traded goods sectors.

b)The economy has two sectors, a booming one and a lagging one.

c) The economy has two traded goods sectors, one booming and the other lagging, and the nontraded goods sector.

d) The economy has three sectors; two sectors are booming, and one sector is lagging.

Suppose a country experiences symptoms of the Dutch Disease. Which of the following policies could help to protect the economy?

a) Discouraging investment in the nonbooming tradable sector

b) Saving some of the proceeds from resource revenue for future use

c) Helping particular companies or industries

d) Discouraging high rates of saving

Suppose gas accounts for 60% of a country’s exports. Which of the following external events may cause the country to exhibit symptoms of the Dutch Disease?

a) An unexpected discovery of large gas deposits elsewhere in the world

b) A realization that the country’s key resource cannot be replaced

c) A sudden increase in the country’s saving rate

d) An unexpected exhaustion of gas deposits elsewhere in the world

Explanation:
According to the economic model developed to explain the Dutch Disease, there is the nontraded goods sector and the two traded goods sectors. Of the traded goods sector, one is booming, while the other is underperforming.

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