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How to Spend a Windfall: Dealing with volatility and capital scarcity

  • Ton S. van den Bremer
  • Frederick van der Ploeg

Intergenerational funds smooth expected consumption across generations in face of an oil windfall. Precautionary buffers or liquidity funds cope with oil price volatility and are a politically more acceptable alternative to hedging. The magnitude of these buffers depends on the volatility of oil prices, the degree of prudence, intergenerational inequality aversion and the GDP share of oil rents. For a net creditor, asset return uncertainty depresses saving unless prudence is large and risk aversion small. For a net debtor, oil price and asset return uncertainty depress borrowing below what is necessary for consumption smoothing. Uncertain returns on domestic investment offers an alternative explanation why capital scarce, developing countries are big savers and small investors. Allowing for infinite horizons, our ballpark estimate of the optimal liquidity buffer for Ghana is very small relative to its intergenerational fund of 24 billion USD even for very high degrees of prudence, for Norway our rough estimate of the optimal liquidity fund is 156 billion USD (given relative prudence of 3) compared with 1.39 trillion USD for the intergenerational fund. Iraq should build an intergenerational fund of 2.81 trillion USD; even for a very low coefficient of relative prudence (1.025) it accumulates an enormous liquidity fund of 1.92 trillion USD. Given capital scarcity and inefficient adjustment of public capital, we argue that Ghana should be concerned about using its windfall for investment rather than hedging against oil price volatility.

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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 085.

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Date of creation: 2012
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Handle: RePEc:oxf:oxcrwp:085
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