2.2. Oil revenue and manufacturing output growth relationship9
2.3.2 Oil revenue growth and manufacturing output growth 11
2.3.2.1 An overview of “Dutch Disease” phenomenon 12
A phenomenon that describes a situation, where a booming sector (natural resources) leads to the rise in the relative prices of non tradable commodities, to that of tradable commodities, and consequently, leading to a total reallocation of factors of production, in favour of the natural resources sector and thereby hampering the growth of non- resource tradable commodities sector is referred to as Dutch Disease (See Corden and Neary, 1982).
One of the prominent models that described Dutch Disease was developed by Corden and Neary (1982). A small economy that produces three commodities was used in the model. Two of the commodities have their prices fixed by the world markets, therefore, these two are subject to international competition and comprise of booming tradable sector (B) and non-booming tradable sector i.e lagging sector (L). The third sector in the model economy is the non-tradable sector (N) where domestic forces of supply and demand determine its prices. Therefore, it is not prone to international competition.
Typically, the booming tradable sector referrers to the oil sector, while the non-booming tradable sector refers to the manufacturing sector and the non-tradable sector is the service sector. However, the assumptions underlying the Dutch Disease hypotheses are as follows; firstly, the definition of the real exchange rate is the ratio of the price of non- booming tradable commodities to that of non-tradable sector. Secondly, the three sectors use common factors of production, which comprise of a non-mobile factor that is capital and a mobile factor that is labour, which can move around among the sectors to optimize its wages. Thirdly, the goods produced have positive income elasticity, in that, they are normal goods. These arrangements lead to a boom which arises in any of the following three ways; (1) A favourable shift in production function occurs, due to a once for all development in the technology in the booming sector (2) a kind of windfall
in the natural resources e.g oil windfall (3), the booming sector produces primarily for export hence its price changes are exogenous.
With this economic set-up Corden and Neary (1982) pointed out that the economy can be affected in two ways, the resources movement effect and the spending effect. Salter diagram in figure 1 describes the effect of the boom on the economy. The vertical axis comprise of the outputs of the tradable sector (TG) which includes both the oil tradable sector and non-oil tradable sector (manufacturing). While the horizontal axis has the output of the (NTG) that is non-tradable sector (services).
The diagram has a production possibility curve (PPC). The PPC is represented by curve SP and it indicates all possible output that can be produced, with the available factors of production and technology, by both the tradable and non tradable sector. Io is the society’s indifference curve and the demand curve. Before the boom, the equilibrium in the economy, initially is E, which marks the intersection of the production possibility curve SP, with the indifference curve Io. The exchange rate initially is the slope of EPo and the tangent of the two curves. At the initial equilibrium E the output of the tradable sector (TG) is OT1 and that of non-tradable sector NTG is OT2.Note that, also at point E , income is equal to expenditure or demand. Oyo describes the demand expansion path if exchange rate is held constant at EPo and national income rises.
Examining the effect of oil windfall, due to the increase in oil income, assuming oil is not consumed locally, thus indicating that the boom will not affect the maximum output of the non-tradable sector OS, but output of tradable sector rises, especially oil.
Therefore the PPC shifts upward from the initial position OP on the vertical axis to OP*. let us assess the spending effect of this situation;
Spending effect
The boom shifts the PPC from SP to SP* and thus bringing a new equilibrium at E* and EE* is the increased oil production, that leads to the boom, but the output of both the no-oil tradable sector and that of non-tradable sector remain at E. The exchange rate
remains the same since E* lies vertically on E, EP1 is parallel to EPo. As income increases, demand for non-tradable goods rises through the expansion path OYo and stay at N, which is a disequilibrium position, since optimum output is at E*.The implication is that the consumers intend to consume at point N but the producers are willing to produce to point E*.
Figure 2.1: The spending effect
Therefore, the excess demand for tradable goods is represented by NM and Note that the output of the non tradable goods still remains at E at the relative price EPo (exchange rate) also excess demand for non-oil tradable commodities, is shown by EM,
while the rest of the same particular line that is ME* is the balance of payment situation.
The implication of the whole situation is that for market clearance in the economy, the exchange rate must rise and it’s shown by EP*, this is necessary to reduce the excess demand for non tradable goods and also to make sure that the balance of payment is restored. Consequently, the new equilibrium will definitely fall between E* and intersection of SP* with the expansion path line OYo. Point D on the diagram is an example the new equilibrium. The summary of the implication is that, oil boom increases demand for non-tradable commodities from M to N, and the real exchange rate appreciates, thus lowering the demand for non tradable goods to N* leading to net rise by MN* which is equal to rise in non tradable output from T2 to T3. Again, considering the implication on the non-oil tradable sector (manufacturing sector), the boom increases demand by EM but the rise in real exchange rate increases it further to EM*. This is a decline in the output of the non-oil tradable sector at T1T4.
At the new real exchange rate (relative price) EP** the domestic output of both the non tradable and non-oil tradable sectors move along the initial production possibility curve SP to a new point D* on the same SP. This represents the new equilibrium of both non- oil tradable sector (manufacturing) and non-tradable sector (services). At this new equilibrium, the effect of the boom now shows that non-oil tradable sector output falls from T1 to T4 while non-tradable sector output rises from T2 to T3. But to cover the increased demand for the output of the non-oil tradable sector, importation of non-oil tradable goods must rise by DD*.
Resource movement effect
Figure 2.2 describes the resource movement effect. Just as we held factor mobility constant, to be able to explain the spending effect, we also hold income elasticity for non tradable goods constant. The implication is that the income consumption curve, which indicates the expansion path in the previous diagram that is Oyo, is now vertically passing through E and intersects SP* at j. Labour will be attracted to the oil
sector from both the non tradable sector and the non-oil tradable secto,r due to the increase in marginal product of labour and wages. With same real exchange rate EP1, B is the new point of production following the boom in the oil sector. Note that the relative prices EP1 is parallel to EPo hence same real exchange rate. The implication of this is there will be a rise in oil sector output and decrease in the non-oil tradable sector output (manufacturing sector) and non tradable output (service sector).
Figure 2.2: The resource movement effect
The resource movement into the oil sector which has depleted the factors of production, available to the two remaining sectors will lead to excess demand for the non -tradable goods. This is shown by point C on the same Figure 2.2 which is the intersection of the
Oyo and EP1. In clearing the market the real exchange rate needs to rise. This means that prices of non-tradable sector goods rises. This will remove the excess demand and thereby cancelling the decline in the output of the non-tradable sector output which is caused by the resource movement effect.
Point D could be the new equilibrium which shows that the output of the non-tradable sector has fallen, compared to its output in the initial equilibrium thus, indicating the effect of the resource movement. Similarly, the output of the non-oil tradable sector (manufacturing) must have declined due to the real exchange rate appreciation.
In conclusion, Corden and Neary (1982) shows that both resource movement and spending effects shift the mobile factor away from the manufacturing sector and currency also appreciates in value. This occurs since we assume that one specific mobile factor and one non-mobile factor is used in all the sectors. The implication is that the non-oil tradable sector (manufacturing) becomes less competitive and consequently, its output continues to fall whenever there is oil boom.
For the non-tradable sector, the results are ambiguous, while the spending effect leads to expansion, the resource movement effect leads to contraction of the sector. The underlying power of spending effect depends on the propensity to consume the output of the non-tradable sector. The propensity to consume the service sector (non-tradable sector output) is relatively high, mostly in the resources endowed countries (Stijns, 2002). But the strength of the resources movement effect depends on the factor intensity in the sectors. The resource movement is more effective where the production process is more labour intensive and in such economy it will be overshadowed by the spending effect.
According to Corden and Neary (1982), the fall in output of the non-booming sector (lagging sector or the manufacturing sector), as a result of resource movement is referred to as direct de-industrialisation. While the currency appreciation caused by the decline in the output of the non-tradable sector as a result of excess demand for its output is referred to as indirect de-industrialisation.
Finally, the theoretical relationship between oil and manufacturing sector is clearly shown in these analyses of Dutch Disease phenomenon, which is a result of the resource curse hypothesis.