Working Paper: CEPR ID: DP5857
Authors: Karlygash Kuralbayeva; David Vines
Abstract: This paper analyzes the impact of terms of trade and risk-premium shocks on a small open economy in an intertemporal, Dutch disease model, with international capital mobility. It is shown that when the economy experiences a permanent improvement in the terms of trade, the Dutch disease effect (real exchange rate appreciation) goes away in the new steady state, while the economy experiences de-industrialization even stronger than in the short-run. Second, a permanent improvement in the terms of trade coupled with a permanent reduction in the risk-premium leads to pro-industrialization and a real exchange rate appreciation. The mechanism behind appreciation of the real exchange rate in the long-run is different from the Dutch disease story. It occurs because reduction in the risk-premium reduces the costs of the production in the economy, and because (non-oil) traded sector benefits more from cheaper capital than the non-traded sector. The economy also accumulates more debt in response to these two shocks in the long-run.
Keywords: capital inflows; dutch disease; external debt; optimizing models; overborrowing; real exchange rate
JEL Codes: E44; F32; F34; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Terms of trade improvement (F14) | Real exchange rate appreciation (F31) |
| Real exchange rate appreciation (F31) | Deindustrialization (L52) |
| Terms of trade improvement + Risk-premium reduction (F16) | Pro-industrialization (O25) |
| Risk-premium reduction (G52) | Decrease in production costs (D24) |
| Decrease in production costs (D24) | Non-oil traded sector benefits more than non-traded sector (F14) |