MACRO ECONOMICS

INDIVIDUAL ASSIGNMENT - 2

DUTCH DISEASE NATARAJ PANGAL

Dutch Disease - An economic condition that, in its broadest sense, refers to negative consequences arising from

large increases to a country's income. It is an economic concept that tries to explain the apparent relationship

between the exploitation of natural resources and a decline in the manufacturing sector. The theory is that an

increase in revenues from natural resources will deindustrialise a nation’s economy by raising the exchange rate,

which makes the manufacturing sector less competitive and public services entangled with business interests. While

it most often refers to natural resource discovery, it can also refer to "any development that results in a large inflow

of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct

investment". The term was coined to describe the decline of the manufacturing sector in the Netherlands after the

discovery of a large natural gas field in 1959.

In 1959 a large reservoir of natural gas was discovered in the Netherlands, which by 1976 earned the country

revenues of some $2 billion in addition to an estimated $3.5 billion of savings in imports. By the mid 1970s, gross

corporate investment had fallen by 15% since the start of the decade, while employment in manufacturing had

declined by 16%. The total level of unemployment had risen from a modest 1.1% to 5.1%, while the share of profits

in national income which had averaged 16.8% in the 1960s had fallen to 3.5% in the first half of the 1970s. In the

1970s, the same economic condition occurred in Great Britain, when the price of oil quadrupled and it became

economically viable to drill for North Sea Oil off the coast of Scotland. By the late 1970s, Britain had become a net

exporter of oil; it had previously been a net importer. The pound soared in value, but the country fell into recession

when British workers demanded higher wages and exports became uncompetitive1.

This process of de-industrialization of the existing manufacturing base was attributed to the upward pressure that the

energy discovery placed on the Guilder and the wage rate, and was dubbed the Dutch Disease. Since then, the term's

use has widened considerably to encompass any situation whereby a country's apparent good economic fortune

ultimately proves to have a net

detrimental effect.

The adjacent diagram illustrates, the

cascading effects of the Dutch

Disease, which can completely

cripple the economy and future

growth of a country by blinding it

with easy and overwhelming amounts

of natural resources revenue. These

revenues distract the nation from

diversifying its economy and

investing in infrastructure to create

stable and long lasting growth2.

1 University of Dublin - Ronnie O'Toole - http://www.tcd.ie/Economics/SER/archive/1998/ESSAY12.HTM2 Republic of Equatorial Guniea - guinea-equatorial.com/Initiatives/?PageID=172

QUESTION 1 – PART A

The Core Model describing Dutch Disease was developed by the economists W. Max Corden and J. Peter Neary

in 19823. The model assumes that there are three sectors namely - the non-traded good sector (includes services) and

two traded good sectors: the booming sector, and the lagging sector. The booming sector is usually the extraction of

oil or natural gas, but can also be the mining of gold, copper, diamonds or bauxite, or the production of crops, such

as coffee or cocoa. The lagging sector generally refers to manufacturing, but can also refer to agriculture. A resource

boom will affect this economy in two ways. In the resource movement effect, the resource boom will increase the

demand for labor, which will cause production to shift toward the booming sector, away from the lagging sector.

This shift in labor from the lagging sector to the booming sector is called direct-deindustrialization. The spending

effect occurs as a result of the extra revenue brought in by the resource boom. It increases the demand for labor in

the non-tradable, shifting labor away from the lagging sector. This shift from the lagging sector to the non-tradable

sector is called indirect-deindustrialization. As a result of the increased demand for non-traded goods, the price of

these goods will increase. However, prices in the traded good sector are set internationally, so they cannot change.

This is an increase of the real exchange rate.

Dutch Disease can also be analyzed using Erling Larsen’s theory, which describes three main factors that explain

why significant amounts of natural resources may hurt the rest of an economy4:

1. The factor movement effect: When oil – for example – is discovered, vast amounts of resources are required

in order to extract it from the ground.  In an economy close to its full productive capacity, some production

factors – such as capital and labour – will not be available for other sectors of the economy as they are directed

towards oil extraction.  The resource sector thus crowds out the rest of the economy.

2. The spending effect:  The discovery of an important quantity of a natural resource is often associated with

large foreign direct investments and, especially in a small open economy such as Canada’s, with large export

revenues.  This inflow of money from abroad puts upward pressure on the domestic currency, which appreciates

and thus makes other exporters less competitive by increasing the relative prices of their goods and services

abroad.  The inflow of resource money may also create excess demand in the domestic economy.  The prices of

production factors, such as labour, also rise, leaving some sectors of the economy unable to cope with the

increased production costs.

3. The spillover-loss effect:  Some sectors of the economy, such as manufacturing, are associated with “positive

externalities.”  These externalities include the development of “know-how,” new technological innovations

and/or the development of new innovative practices.  Such new developments can benefit other sectors, which

is why the phenomenon is referred to as a “spillover.”  For example, outsourcing from large companies may

result in technological transfers to smaller companies.  Also, export-oriented manufacturers, because they face

international competition, need to become more competitive.  The resulting increase in productivity affects the

entire economy as new methods of production are adopted by other domestic companies in order to remain

competitive.  Resource sectors, on the other hand, are often associated with fewer positive externalities for the

rest of the economy.

3 All Experts - http://en.allexperts.com/e/d/du/dutch_disease.htm4 Parliamentary Information and Research Service - Philippe Bergevin - 31 Mar 2006 - Energy Respources: Boon or Curse for the Canadian Economy?- http://www.parl.gc.ca/information/library/PRBpubs/prb0586-e.htm

These three factors become especially apparent when resources are exhausted or their prices fall to a point where it

is no longer profitable to extract them. If other sectors of the economy have been neglected for many years, the

country may face significant challenges in restoring their competitiveness. Since energy resources are usually non-

renewable and their prices relatively volatile, these problems may appear sooner rather than later.

In general a stronger Canadian Dollar has negative effect on Canadian exporters. As the Canadian Dollar becomes

more valuable, the cost of Americans of buying Canadian products increases, resulting in lower Canadian exports.

At the same time, many Canadian companies that may not export, but do compete in the domestic market against

U.S. products, will have a more difficult time doing so as a higher exchange rate lowers the relative cost of foreign

goods. A survey conducted by Bank Of Canada5 and another conducted by Business Outlook6 clearly articulates the

impact of appreciation of the Canadian currency on various industries. Following are the results of the survey

conducted: -

List of industries adversely effected by the strong Canadian Dollar are : -

As reflected in the graphs the manufacturing industries would be the most impacted by a strong Canadian Dollar.

The following graph further indicates which industry within manufacturing sector would be impacted the most7 : -

5 Bank of Canada - Adjusting to the Appreciation of the Canadian Dollar - http://www.bank-banque-canada.ca/en/bos/2006/spring/adj_e_0406.pdf6 Jean Mair, Calgary Regional Office - Business Outlook Survey - http://www.bankofcanada.ca/en/review/autumn05/mair.pdf7 Parliamentary Research Branch - Library of Parliament - Michael Holden- http://dsp-psd.pwgsc.gc.ca/Collection-R/LoPBdP/EB-e/prb0321-e.pdf

Figure 1: Survey conducted by Business Outlook Figure 2: Survey conducted by Bank of Canada

QUESTION 1 – PART B

Following is the list of industries that would be impacted adversely due to the appreciation of Canadian Dollar : -

The tourism industry will be impacted by the appreciation of the Canadian currency, as foreign tourists would

find spending a leisure holiday in Canada expensive. Furthermore, Canadians living close to the U.S. border

would find it economical to go to U.S. for a holiday.

This will be also impact the outsourcing industry as Canada would lose the cost-effective advantage that U.S.

companies seek for.

As mentioned earlier given the impact

on export, the manufacturing industry

would be impacted the most. The

adjacent graph8 indicates the degree to

which various manufacturing industries

would be impacted, which reflects that

the logging industry would be severely

impacted. Also, Auto industry

manifested by declining exports, would

be severely impacted.

The education sector would be impacted, since appreciating currency would make attracting foreign students

difficult.

Following is the list of industries that will be positively affected by the rising Canadian dollar:

A strong currency has benefited the wholesale and retail industry. With consumer buying power increasing for

local as well as foreign products/services, the Retail industry has benefitted in Canada.

Utility companies that maintain the local infrastructure have been affected positively, since there is an increase

in investment as well as an increase in consumer buying power. Energy companies would be benefited, since

they import electricity and gas from U.S.

Given that Canada imports most of its technology and new machineries from U.S. there is a high influx of

new technologies and machineries being imported, which has further improved the productivity and quality of

goods produced.

Thus, as enunciated a strong Canadian currency would be beneficial for some industries, but at the same time would

be detrimental for other industries. However, though some Canadian industries will be adversely affected by a

higher dollar, the effect on Canadian economy is far from unequivocally negative. Several aspects of the Canadian

economy will benefit from a stronger exchange rate.

8 Parliamentary Research Branch - Library of Parliament - Michael Holden - http://dsp-psd.pwgsc.gc.ca/Collection-R/LoPBdP/EB-e/prb0321-e.pdf