Terms of Trade Shocks in an Intertemporal Model: Should We Worry about the Dutch Disease or Excessive Borrowing?

David Vines and Karlygash Kuralbayeva

No 5857, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 (search for similar items in EconPapers)
JEL-codes: E44 F32 F34 F41 (search for similar items in EconPapers)
Date: 2006-10
New Economics Papers: this item is included in nep-dev and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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