Absorbing a Windfall of Foreign Exchange: Dutch Disease Dynamics

38 Pages Posted: 29 Nov 2010

See all articles by Rick van der Ploeg

Rick van der Ploeg

University of Oxford

Anthony J. Venables

University of Oxford; Centre for Economic Policy Research (CEPR)

Date Written: October 2010

Abstract

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.

Keywords: absorption constraints, absorptive capacity, aid, Dutch disease, natural resources, windfall

JEL Classification: 011, E21, E22, F10, F35, H63, O16, Q33

Suggested Citation

van der Ploeg, Frederick and Venables, Anthony J., Absorbing a Windfall of Foreign Exchange: Dutch Disease Dynamics (October 2010). CEPR Discussion Paper No. DP8086. Available at SSRN: https://ssrn.com/abstract=1714858

Frederick Van der Ploeg (Contact Author)

University of Oxford ( email )

Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom

Anthony J. Venables

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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