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Absorbing A Windfall Of Foreign Exchange: Dutch disease dynamics

  • Rick van der Ploeg
  • Anthony J Venables

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.

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Paper provided by Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford in its series OxCarre Working Papers with number 052.

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Date of creation: 2010
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Handle: RePEc:oxf:oxcrwp:052
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