Question

Based on class lectures and papers by Max Corden, Christine Ebrahimzadeh, Milan Brahmbhatt, Otaviano Canuto and Ekaterina Vostroknutova as well as the paper by Antonio Cabrales and Esther Hauk, discuss in details the economic theory of the Dutch Disease, with particular references to the Australia economy. According to Max Corden, what are the policy options for Australia when faced with the Dutch Disease? Discuss in details.

Political institutions and the curse of natural resources - Antonio Cabrales, Esther Hauk 17 June 2011

Dealing with Dutch Disease - Milan Brahmbhatt, Otaviano Canuto, and Ekaterina Vostroknuto

The Dutch Disease in Australia: Policy Options for a Three-Speed Economy - W. Max Corden

Answer 1

From 2005 to 2011 the Australian mining industry grew about 90%. This was by value measured in Australian dollars. During the same period the value of Australian GDP grew about 43%. Exports of the mining industry’s products –principally iron ore and coal – grew 140% in value. This reflected, to a great extent, increases in prices –in fact a 41 % increase in Australia’s terms of trade. The cause was primarily an increase in demand from China. With GDP in the rest of the economy growing by 37% over this period, all this is summed up by the popular Australian term “the two speed economy”.

The mining boom was the principal –but by no means only –cause of a substantial 31% real appreciation of the Australian dollar over the period, (as measured by an index of the trade -weighted exchange rate). In turn this real appreciation had an adverse effect on at least some (and perhaps many) import -competing and non-mining export industries.. These were the losers from the mining boom.

It is these losers that the theory of the Dutch Disease focuses on. Thus Australia is now really not a “two-speed” but a “three speed” economy. The fast moving part is the Booming Sector, the slow moving or even declining part is the Lagging Sector, and the rest – where there are more likely to be gains – is the Non-tradable Sector.

The whole economy can be divided into the Non-tradable Sector and the Tradable Sector. The Non-tradable Sector consists of those industries or activities the prices of which are determined by demand and supply domestically. The Tradable Sector consists of export and import -competing industries. These are industries the prices of which are determined in the world market, set by world prices and the exchange rate.

In turn the Tradable Sector can be divided between the Booming Sector and the Lagging Sector. In Australia the Booming Sector consists of the mining industries, principally iron ore and coal producers and exporters. The Lagging Sector consists of the export and import - competing industries that lag behind (as the name suggests).

This sector –which is the locus of the Dutch Disease problem –consists of a part of manufacturing industry, of part of agriculture and of certain services, principally those provided by the tourism industry and the export -of-education industry. Their prices are given in the world market and have not risen in the way that booming sector prices have. Hence an exchange rate appreciation lowers their prices in terms of Australian dollars. These Dutch Disease industries are the losers in the three -speed economy. Thus the economy outside the Booming Sector can be divided into two parts, namely the Non-tradable Sector and the Lagging Sector. This division is act ually an over-simplification and there are various complications I shall discuss below. But for the time being it is helpful to adhere to the simple classification.

Going back to the beginning of our story, it follows that the mining or resources boom brings about both an increase in spending on Non-tradables, which is expansionary, and an exchange rate appreciation that is contractionary. The first effect raises the outputs of Non-tradables and the second effect reduces the profitability and outputs in the Lagging Sector, which is the Dutch Disease effect.

Internal Balance:

Interest rate policy is managed by the RBA to maintain “internal balance”. This might be aimed at keeping the inflation rate or the rate of unemployment constant, or some compromise be tween these two objectives. With both an expansionary and acontractionary effect resulting from the resources boom, the RBA might have to adjust the interest rate either way. Suppose that with a given interest rate, the net effect is expansionary. Then the RBA would raise the interest rate, and this would contract the economy through two channels: aggregate spending would decline in the usual way, and foreign capital would be drawn into Australia through the higher interest rate, and this would increase the appreciation of the exchange rate. Of course, the higher interest rate would also lead to less domestic capital outflow.