**T**he purpose of this paper is to examine the short-run macroeconomic implications of natural resource availability—as well as its exhaustibility—in the case of Venezuela. Although considerable attention has been paid in the economic literature to the manner in which the economies of oil producers such as Venezuela are influenced by variations in the flow of income generated by oil resources, the models used in the studies have in general ignored two important distinguishing characteristics of oil-based economies. The first relates to the possible “confidence effect” that resource availability might have on the behavior of economic agents. This effect has been highlighted by the studies of the “Dutch disease”—that is, the problem of deindustrialization attributable to a booming export sector (Buiter and Purvis (1983), Corden and Neary (1982), Eastwood and Venables (1982), Neary and van Wijnbergen (1984), and van Wijnbergen (1984)). It arises from the impact of resource availability on future expected income, which can in turn influence saving behavior, the pattern of expenditure, and the composition of asset portfolios. The second important characteristic is the exhaustibility of oil resources. Although the economic literature is replete with studies of the implications of the exhaustibility of petroleum resources for optimal production and price strategies in petroleum-based economies, the short-run macroeconomic models of such economies have in general sidestepped the question of the depletability of the main source of income (Aghevli (1977), Aghevli and Sassanpour (1982), Khan (1976), and Knight and Mathieson (1980)). Although these models do recognize that the exhaustibility of oil has major implications from the point of view of economic management, in general they consider exhaustibility as a long-run concept with little or no consequences in the short run. The validity of such a position is questionable, however, because exhaustibility is likely to influence expectations about future income, thus inducing shifts in perceived wealth that may in turn affect private sector confidence and its behavior in the short run.

The analytical framework of this paper explicitly incorporates these key characteristics of major oil-based developing countries.^{1} The analysis suggests that, in the case of Venezuela, the impact of an oil price shock on the economy becomes considerably more pronounced once these features are taken into account. In particular, such a disturbance would lead to significantly greater variations both in the balance of payments and in domestic prices than is suggested by earlier models that ignore these features of resource-based economies. Consequently, remedial policies adopted in the face of such disturbances would need to be greater in intensity and, sometimes, longer in duration than those suggested by previous studies.

The model is applied to the Venezuelan economy over the period 1965-81. The choice of country was dictated both by data availability and by a desire to preserve the general characteristics of the model as far as possible, thus to make it applicable to other oil producing developing countries. Venezuela seems especially suitable for this purpose because it is a small and relatively liberal economy where the generality of the model specification could be preserved.

Moreover, during the sample period Venezuela maintained a free exchange system with no restriction on capital flows. Since early 1983, however, the Venezuelan exchange system has undergone major modifications, rendering it highly restrictive. In particular, a multiple exchange system has been introduced, and all private capital transactions are now channeled through the free exchange market and are subject to prior authorization. Choice of the period of study was based on these considerations.

The rest of the paper is organized as follows. The specification of the model is presented in Section I, followed in Section II by a discussion of the estimation results and their policy implications. Some simulation exercises are reported in Section III to highlight the impact of exogenous shocks on the economy, and the conclusions of the study are summarized in Section IV.

## I. Model Specification

In the tradition of the “warehouse” models of oil supply, it is assumed that oil is stored in a warehouse so that the costs or technical difficulties associated with its production or exportation are negligible. The usage rate is also assumed not to be constrained by any conservation motive. The analysis thus abstracts from the issues related to optimal pricing and production strategies over time, on which much of the literature on exhaustible resources has focused. This implies that, given an exogenous foreign price of oil, the rate of depletion is always equal to the quantity demanded at the going price. Oil revenues can thus be treated as exogenous (Motamed (1979)).

This assumption is not too restrictive because it is not always possible for a country such as Venezuela, which is a member of the Organization of Petroleum Exporting Countries (OPEC), to vary unilaterally its price or output sufficiently to achieve a targeted income. Moreover, so long as the price elasticity of demand for oil from a particular country is infinitely large, an output restriction is sufficient to render oil revenues exogenous. Although the global elasticity of demand for oil may be low, demand for a specific country’s oil exports need not necessarily be low. An approximate measure of this elasticity is given by

where

ϵ = the price elasticity of the world demand for oil from country

*i*ϵ

_{ω}= the price elasticity of world demand for oilη = the supply elasticity of other oil producers

*s =*the share of country*i*in the world oil market.

Although this is an approximate measure, since it assumes that there is excess capacity in the combined production of competitors, it shows that the price elasticity of demand for oil from country *i* is larger, the smaller is its share of the market. For Venezuela, this share has varied between 3 percent and 5 percent. In the limiting case when the supply elasticity of other producers (η) is zero, the elasticity of demand for Venezuelan oil can be between 20 to 33 times larger than the elasticity of the world demand for oil. Given a large elasticity of demand for Venezuelan oil, the assumption of exogenous oil revenue is not too restrictive.

The role of oil as an intermediate input is left out of the model. As a result, non-oil producing sectors are not directly influenced by changes in oil prices.^{2} Such an omission is not too restrictive if the size of the non-oil (including petrochemical) sector is small in relation to the size of the economy, or if the domestic use of oil is relatively unimportant (as is the case in many oil exporting developing countries). Moreover, in such countries the domestic production sector is usually insulated from movements in the export price of oil as a matter of policy. The cost of oil input in domestic production is thus not sensitive to developments in the oil price, and the impact on domestic production of higher oil revenues generated through price hikes does not work through the oil input component of domestic production.

The impact of oil resources does, however, enter the model on the demand side. Both the demand for real balances and the private demand for consumption and investment goods are influenced by these resources. In contrast to some recent theoretical models that recognize the separate impact of oil resources on demand but implicitly assume that these revenues accrue directly to the private sector (Eastwood and Venables (1982), Buiter and Purvis (1983), and Neary and van Wijnbergen (1984)), in the present model the influence of these resources on private behavior is indirect because oil revenues are assumed to be received entirely by the government. This indirect influence can be interpreted as the confidence effect of the oil wealth. It arises because the stock of oil may be viewed by the society as accumulated savings or as a source of wealth to be drawn upon in the future. The knowledge of the existence of this source of wealth, from which eventually all the inhabitants of the country can be expected to benefit, affects the public’s confidence about prospects for future income, leading to adjustments in their permanent income. This will, in turn, have an influence on saving behavior, expenditure patterns, and the composition of asset portfolios. In other words, the indirect impact of oil wealth on current expenditures and desired holdings of real balances works not through a rise in current disposable income, but through expectations about future income.

In the oil-based economies, the large size of export earnings accruing to the government relative to the size of the economy imparts more importance to the operations of the government than in other developing countries. Because the oil sector is typically characterized as an enclave sector, the government’s operations serve as the main link between that sector and the rest of the economy. This linkage implies that the loss of oil export proceeds will not automatically lead to a decline in aggregate demand. Since the loss falls entirely on the government, specific adjustment measures will be required to bring demand into line with resource availability. In contrast, where the economy is dependent on the export of a single agricultural crop, reduced crop prices abroad will result in lower incomes for many households as well as for the government, thereby leading to a decline in aggregate demand and reducing the extent of required adjustment in financial policy.^{3}

The collection of government receipts from oil exports, all of which are denominated in foreign currency, entails no deflationary impact because it does not represent a withdrawal from the domestic income stream. Similarly, the expenditure of these revenues on imports of goods and services does not immediately increase domestic liquidity and is not inflationary. Moreover, there is an immediate coincidence of oil-financed domestic expenditure with increases in domestic liquidity that may to some extent blur the distinction between monetary and fiscal policies.^{4} The rate of growth of the money supply is, therefore, greatly influenced by the government’s domestic operations. The domestic budget balance—that is, the difference between the government’s domestic revenues and domestic expenditures—becomes a highly useful concept in analyzing the impact of government operations on domestic liquidity.

Unlike much of the earlier work on macroeconomic models undertaken at the IMF, the model in this paper does not follow in a purely monetarist tradition but takes into account structural factors underlying inflationary and growth impulses. The model recognizes the interdependence of commodity and money markets by explicitly allowing for the spillover of disequilibrium effects across different markets. The level of absorption and prices are thus influenced by disequilibrium in both money and commodity markets. Moreover, in contrast to earlier models that focus on aggregate private expenditures, an explicit investment function is incorporated to isolate the impact of oil resources on productive potential. The specification of the model in disequilibrium form also helps to provide information on the lag structure of the economy.

The model consists of 9 behavioral equations and 8 identities explaining 17 endogenous variables. The definition of variables is given in Table 1, and the model is reproduced in Table 2. Lowercase letters denote the logarithm of the corresponding uppercase variable deflated by the price index, except *p, p ^{t}*, and

*p*, which denote the logarithm of the corresponding price indices

^{n}*P, P*, and

^{t}*P*. The symbols

^{n}*i*and

*i*represent, respectively, domestic and foreign interest rates measured in percentages.

_{f}**List of Variables**

**List of Variables**

Variable | Definition |
---|---|

Endogenous variables | |

CON | Actual private consumption expenditures |

CON^{d} | Private demand for consumer goods |

CP | Credit to private sector |

DR | Government domestic revenues |

E | Desired private expenditures |

G | Government expenditure |

GDP | Gross domestic product |

GR | Government revenues |

IM | Imports of goods and services |

IM^{d} | Desired imports of goods and services |

KF | Private investment (capital formation) |

M^{d} | Demand for money balances |

MS | Nominal money stock broadly defined (M2) |

NFAB | Net foreign assets of the banks |

FNACB | Net foreign assets of the central bank |

PKI | Net private capital inflow |

P | Domestic price level (index) |

P^{n} | Price of nontraded goods (index) |

X^{n} | Real exports of goods and services other than oil |

y | Non-oil GDP |

y^{d} | Demand for non-oil output |

Exogenous variables | |

BOP | Residual item in the balance of payments (including, on a net basis, all the above-the-line |

variables except the trade balance, nonfactor services, government capital inflow, and short-term private capital inflows) | |

DA | Net domestic assets of the central bank |

DOC | Domestic consumption of oil |

F | Expected oil wealth |

GDE | Government domestic expenditure |

i | Expected domestic interest rate |

i_{f} | Foreign interest rate adjusted for expected exchange rate change |

INV | Inventories calculated from national accounts data |

MM | Money multiplier |

OR | Oil revenues |

P^{t} | Prices of traded goods |

PIM | Private Imports |

UCB | Change in cash balances of the treasury |

YUS | Nominal U.S. GDP |

π | Price of oil |

**List of Variables**

Variable | Definition |
---|---|

Endogenous variables | |

CON | Actual private consumption expenditures |

CON^{d} | Private demand for consumer goods |

CP | Credit to private sector |

DR | Government domestic revenues |

E | Desired private expenditures |

G | Government expenditure |

GDP | Gross domestic product |

GR | Government revenues |

IM | Imports of goods and services |

IM^{d} | Desired imports of goods and services |

KF | Private investment (capital formation) |

M^{d} | Demand for money balances |

MS | Nominal money stock broadly defined (M2) |

NFAB | Net foreign assets of the banks |

FNACB | Net foreign assets of the central bank |

PKI | Net private capital inflow |

P | Domestic price level (index) |

P^{n} | Price of nontraded goods (index) |

X^{n} | Real exports of goods and services other than oil |

y | Non-oil GDP |

y^{d} | Demand for non-oil output |

Exogenous variables | |

BOP | Residual item in the balance of payments (including, on a net basis, all the above-the-line |

variables except the trade balance, nonfactor services, government capital inflow, and short-term private capital inflows) | |

DA | Net domestic assets of the central bank |

DOC | Domestic consumption of oil |

F | Expected oil wealth |

GDE | Government domestic expenditure |

i | Expected domestic interest rate |

i_{f} | Foreign interest rate adjusted for expected exchange rate change |

INV | Inventories calculated from national accounts data |

MM | Money multiplier |

OR | Oil revenues |

P^{t} | Prices of traded goods |

PIM | Private Imports |

UCB | Change in cash balances of the treasury |

YUS | Nominal U.S. GDP |

π | Price of oil |

**List of Equations**

**List of Equations**

Equation Number | Equation |
---|---|

Behavioral equations | |

(1) | $m={a}_{1}+{a}_{2}y+{a}_{3}f+{a}_{4}i+{a}_{5}{i}_{f}+{a}_{6}{m}_{t-1}$ |

(2) | $con={b}_{1}+{b}_{2}y+{b}_{3}f+{b}_{4}{EFD}_{t-1}+{b}_{5}{con}_{t-1}$ |

(3) | $KF/P={u}_{0}+{u}_{1}(Y/P)+{u}_{2}q+{u}_{3}(F/P)+{u}_{4}{(K/P)}_{t-1}$ |

(4) | $\mathrm{\Delta}p={c}_{1}+{c}_{2}\mathrm{\Delta}{y}^{d}+{c}_{3}\mathrm{\Delta}k+{c}_{4}\mathrm{\Delta}{EFD}_{t-1}+\mathrm{\Delta}{p}^{t}$ |

(5) | $\mathrm{\Delta}y={D}_{1}+{D}_{2}{y}^{d}+{D}_{3}{EFD}_{t-1}+{D}_{4}({p}^{n}-{p}^{t})+{D}_{5}{y}_{t-1}$ |

(8) | $im={k}_{1}+{k}_{2}({p}^{n}-{p}^{t})+{k}_{3}e+{k}_{4}g+{k}_{5}{\text{\hspace{0.17em}}im}_{t-1}$ |

(10) | $dr={l}_{1}+{l}_{2}y$ |

(11) | $g=\lambda gr+(1-\lambda ){g}_{t-1}$ |

(13) | $PKI={w}_{0}+{w}_{1}(i-{i}_{f})+{w}_{2}\mathrm{\Delta}GDP+{w}_{3}YUS$ |

Identities | |

(6) | ${Y}^{d}={CON}^{d}+KF+G+{X}^{n}$ |

(7) | $e=\mathrm{log}({CON}^{d}/P+KF/P)$ |

(9) | $GR=OR+DR$ |

(12) | ${X}^{n}=Y-CON-KF-G+IM-\mathrm{\Delta}INV+DOC$ |

(14) | $GDP=Y+OR+DOC$ |

(15) | $\mathrm{\Delta}M=G-DR+{X}^{n}-IM+\mathrm{\Delta}CP+PKI+BOP$ |

(16) | $EFD={(M/P)}^{d}-{(M/p)}_{t-1}-\mathrm{\Delta}(DA/P)MM$ |

(17) | $F={\pi}_{t-1}S$ |

**List of Equations**

Equation Number | Equation |
---|---|

Behavioral equations | |

(1) | $m={a}_{1}+{a}_{2}y+{a}_{3}f+{a}_{4}i+{a}_{5}{i}_{f}+{a}_{6}{m}_{t-1}$ |

(2) | $con={b}_{1}+{b}_{2}y+{b}_{3}f+{b}_{4}{EFD}_{t-1}+{b}_{5}{con}_{t-1}$ |

(3) | $KF/P={u}_{0}+{u}_{1}(Y/P)+{u}_{2}q+{u}_{3}(F/P)+{u}_{4}{(K/P)}_{t-1}$ |

(4) | $\mathrm{\Delta}p={c}_{1}+{c}_{2}\mathrm{\Delta}{y}^{d}+{c}_{3}\mathrm{\Delta}k+{c}_{4}\mathrm{\Delta}{EFD}_{t-1}+\mathrm{\Delta}{p}^{t}$ |

(5) | $\mathrm{\Delta}y={D}_{1}+{D}_{2}{y}^{d}+{D}_{3}{EFD}_{t-1}+{D}_{4}({p}^{n}-{p}^{t})+{D}_{5}{y}_{t-1}$ |

(8) | $im={k}_{1}+{k}_{2}({p}^{n}-{p}^{t})+{k}_{3}e+{k}_{4}g+{k}_{5}{\text{\hspace{0.17em}}im}_{t-1}$ |

(10) | $dr={l}_{1}+{l}_{2}y$ |

(11) | $g=\lambda gr+(1-\lambda ){g}_{t-1}$ |

(13) | $PKI={w}_{0}+{w}_{1}(i-{i}_{f})+{w}_{2}\mathrm{\Delta}GDP+{w}_{3}YUS$ |

Identities | |

(6) | ${Y}^{d}={CON}^{d}+KF+G+{X}^{n}$ |

(7) | $e=\mathrm{log}({CON}^{d}/P+KF/P)$ |

(9) | $GR=OR+DR$ |

(12) | ${X}^{n}=Y-CON-KF-G+IM-\mathrm{\Delta}INV+DOC$ |

(14) | $GDP=Y+OR+DOC$ |

(15) | $\mathrm{\Delta}M=G-DR+{X}^{n}-IM+\mathrm{\Delta}CP+PKI+BOP$ |

(16) | $EFD={(M/P)}^{d}-{(M/p)}_{t-1}-\mathrm{\Delta}(DA/P)MM$ |

(17) | $F={\pi}_{t-1}S$ |

### Demand for Real Balances (m^{d})

The demand for real balances is assumed to depend on real non-oil income (*y*), the expected oil wealth (*f*), and the domestic (i) and foreign (*i _{f}*) interest rate(s).

^{5}The relationship between expected oil wealth and the demand for money represents a confidence or psychic factor, as discussed earlier, but it is also consistent with Friedman’s (1959) hypothesis that demand for real balances depends on permanent rather than actual income. The inclusion of both non-oil income and expected oil wealth in the demand for money equation also permits a test of the plausible hypothesis that the elasticity of demand for money with respect to oil should differ substantially from that with respect to non-oil income, reflecting the dominant role of the government in oil-related transactions.

In a relatively open economy such as that of Venezuela, both foreign and domestic interest rates (*i _{f}*)and

*i*, respectively) should be included in the demand for money equation to represent the yield on foreign and domestic assets (Hamburger (1977)). In a completely open economy these assets are perfectly substitutable, so that the movements in their yields are perfectly correlated, and there is no need to include both interest rates in the equation. Because the degree of openness is an empirical question, however, the demand function is specified to include both interest rates (the time subscripts

*t*have been suppressed throughout the paper for ease of presentation):

The actual stock of real balances is assumed to adjust with a lag to the desired stock:

where μ is the speed of adjustment and A is the first difference operator:

The above relationships result in the following estimating equation:

Where a_{2}, a_{3}, a_{4}, a_{6}> 0 and a_{5}< 0.

### Private Consumption Expenditures (con)

The level of aggregate private consumption rises whenever there is an excess private demand for consumer goods:

where *con ^{d}* denotes the desired level of private consumption. It is assumed to vary directly with non-oil real income (

*y*) and expected oil wealth (

*f*), and inversely with the level of monetary disequilibrium in the previous period:

where *EFD* denotes the level of disequilibrium in the money market, as defined later in this section (in the subsection “Monetary Dis equilibrium”). Eliminating *con ^{d}* from the above relationships yields the estimating equation:

Where b_{2}> 0, b_{3}> 0, b_{4}< 0, and a_{5}< 0.

### Private Investment (KF)

The desired level of real private capital stock (*K/P) ^{d}* is assumed to be a linear function of real non-oil income

*(Y/P)*, expected real oil wealth

*(F/P)*, and the opportunity cost of capital (q):

*q* is measured by the rental wage ratio,

where *W* represents the nominal wage index and ∏ denotes the rate of change in capital goods prices.

An expansion in non-oil income would raise the desired capital stock, whereas an increase in the rental wage ratio would lower it by encouraging substitution of labor for capital. However, the impact of an increase in expected oil wealth on desired private capital stock is ambiguous. Because the immediate beneficiary of higher income from oil is the government, the direction of the effect would depend on the expected pattern of government expenditure. That is, the desired private capital stock may rise if government expenditures are viewed as complementary to private investment (as could be the case with government expenditures channeled to infrastructural investment). The desired private capital stock will decline if government expenditures are expected to be of a competing nature, concentrated on projects usually undertaken by the private sector. The sign of the coefficient of *F/P* is therefore indeterminate a priori.

In each period the actual level of the capital stock adjusts partially to the desired level:^{6}

The level of real gross fixed capital formation *(KF/P)* is given by

where DEP denotes depreciation of the capital stock, assumed to be a constant proportion Θ of the capital stock in the previous period; that is,

The estimating relationship for *KF/P* is thus given by

Where *u*_{1}>0, *u*_{2}<0, and *u*_{4} = Θ - *u*.

### Domestic Price Inflation

The domestic price level (*p*) is assumed to be a weighted average of the prices of traded and nontraded goods *(p ^{t}* and

*p*, respectively):

^{n}Movements in prices of nontraded goods result from variations in money market disequilibrium or from changes in the excess of demand over potential supply in the goods market *(ECD): ^{7}*

If potential output is assumed to be proportional to the real capital stock *(k)*, one can write

where *y ^{d}* represents the level of demand in the goods market. These relationships give the following estimating equation for domestic inflation:

Where *c*_{2}>0, *c*_{3} =-*c*_{2} < 0, and *c*_{4} < 0.

### Growth of Non-Oil Output (y)

The supply of non-oil output (y) responds to excess demand in the commodity market, to the disequilibrium in the money market (with a time lag), and to relative prices:

An improvement in the terms of trade in favor of nontraded goods could be expected to stimulate the supply of non-oil output because nontraded goods make up the bulk of domestic non-oil production. However, the increase in the relative price of nontraded goods may shift the consumption pattern away from such commodities, thus inducing a cutback in production. The sign of the coefficient d_{4} is therefore indeterminate a priori.

After rearrangement, the estimating equation can be derived as follows:

Where *D*_{2}>0, *D*_{3}< 0, and 0 > *D*_{5}=-*d*_{2}/(1+*d*_{2})> -1.

The demand for domestic non-oil output *(Y ^{d})* comprises public (G) and private demand for goods and services and demand for non-oil exports(

*X*):

^{n}n### Imports (im)

The level of actual real imports *(im)* rises whenever there is excess demand for imports:

The desired level of imports (*im ^{d})* is assumed to depend on planned private expenditures (e), on government real expenditures

*(g)*, and on the relative prices of traded and nontraded goods:

The variables *e* and *g* enter the import function separately to account for the difference in the import content of private and government expenditures. The underlying demand for private expenditure is composed of desired consumption and planned investment:

In the present formulation, the planned and actual levels of investment are assumed to be equivalent. In other words, plans to adjust to the desired capital stocks at a given speed are assumed to be fully realized.

The following equation can thus be derived:

Where *k*_{2}>0, *k*_{3}>0, *k*_{4}>0, and 1≥*k*_{5}=1-*k*_{0}≥0.

### Government Revenues (GR) and Expenditure (G)

Government revenues *(GR)* consist of oil revenues *(OR)* and non-oil revenues *(DR)*:

Non-oil revenues are related to non-oil income:

Given the exogeneity of the price and demand for oil, the governments of oil producing countries can exercise little discretionary control over the bulk of their revenues, particularly in the short run. As a result they have attempted, to a larger extent than other countries, to adjust their expenditures in line with revenues. Indeed, studies of the Islamic Republic of Iran and of Indonesia have shown that the level of government expenditure in each period is established in these countries in such a way as to move toward a balanced budget over time (Aghevli and Sassanpour (1982) and Sassanpour (1985)). Adopting such an assumption allows the following relationship to be specified:

which results in the estimating equation

### Non-Oil Exports *(X*^{n})

^{n})

Non-oil exports are determined as a residual from the income identity:^{8}

where ΔINV is the change in inventories, and *DOC* is domestic consumption of oil. Non-oil exports are thus affected by developments on both the demand and supply sides of the economy.

### Capital Flows *(PKI)*

Capital flows usually respond to a variety of factors that no single relationship can adequately capture. Nevertheless, in the present model it is assumed that the differential in expected returns on domestic and foreign assets and changes in domestic and foreign incomes bring about changes in desired asset holdings, thus generating capital flows. Because most capital movements are to and from the United States, foreign variables refer to that country:

where

and *YUS* denotes nominal U.S. GDP. Note that estimating a net capital flow equation of the type specified assumes that foreign and domestic assets are not perfect substitutes.^{9} If assets are perfectly substitutable, this equation should be replaced by an interest arbitrage equation linking *i* and *i _{f}*.

### The Money Supply Identity

As noted earlier, the impact of government operations on domestic liquidity can be measured by the government’s domestic budget balance; that is, by the difference between domestic revenues and domestic expenditures *(GDE)*. In other words, even if the overall budget is in balance or in surplus, the net impact of the government’s operations can be expansionary. It is more useful, therefore, to write the money supply identity in terms of the domestic budget balance, as follows:^{10}

where *PIM* denotes private imports, *CP* stands for credit to the private sector, and *BOP* represents a residual item in the balance of payments. Because complete data are not available for the government’s domestic expenditures *(GDE)*, the above identity is rearranged in terms of total government expenditure and total imports (Aghevli and Sassanpour (1982)):

In equation (15), *BOP* is exogenous, and all the other variables except *CP*are determined from the equations specified earlier. Therefore, this relationship now determines the flow of credit to the private sector.

### Monetary Disequilibrium

Two measures of monetary disequilibrium have been used in the literature. The first embodies a stock concept, whereby disequilibrium is measured in terms of the deviation of the actual stock of real balances from demand:^{11}

where *ESD* is the excess stock demand for real balances.

This concept ignores the role that domestic credit expansion during the period plays in closing the real balance gap. Another measure, proposed by Blejer (1977) and Sundararajan (1986) among others, focuses on the concept of “flow disequilibrium,” which makes appropriate allowances for the authorities’ attempt to fill the real balance gap through credit creation. Accordingly, the flow excess demand *(EFD)* is defined as

where *MM* is the money multiplier and ΔDA refers to the change in the net domestic assets of the central bank during the period.

The choice of the disequilibrium concept has important implications for the dynamic effects of monetary policy in empirical models dealing with small open economies. In this study, the disequilibrium concept represented in equation (16) is used.

### Expected Income from Oil Extraction

The expected oil wealth *(F)* in each period is defined as

where

*PV =*the present value of the streams of income derived from oil over the lifetime of the resource*d*= the rate of discount*Q*= the rate of oil exploitation at time_{i}*i**π*= the price of oil at time_{i}*i**T*= the time of depletion of the oil stock*E*= the expectations operator._{t}

Because *T* is unknown, this relationship cannot be readily incorporated in the model. For empirical purposes, a simplified version could be derived on the assumption that the expected rate of oil price inflation is equal to the discount rate. It is well known from the theory of exhaustible resources that the optimal rate of extraction is determined at the point where the marginal productivity of the resource in all its uses is equalized (see Hotelling (1931) and Davarajan and Fisher (1981)). The expected rate of oil price inflation represents the marginal productivity of oil if left underground, whereas the rate of return on financial assets (or the interest rate) represents the marginal productivity of the resource if invested in financial assets. Thus, at the optimal rate of extraction, the rate of oil price inflation is equal to the interest rate.

In contrast, if expected oil price inflation is higher than the rate of interest, then the optimal policy dictates keeping the resource underground; if it is lower, no equilibrium rate of extraction will exist because it would be optimal to exhaust the resource instantaneously.^{12} Assuming that the social discount rate is equal to the rate of interest,^{13} and denoting the rate of oil price inflation in period *i* by *r _{i}*, one can write

where S is the stock of proven oil reserves in time t. Assuming static oil price expectations, E(π_{t})=π_{t-1}, the following relationship is obtained:

This simple relationship represents the confidence or wealth effect of natural resource availability. It also embodies the concept of exhaustibility of oil (since *S _{t}* is declining over time), so that this important feature of the oil producing countries is built into the model, albeit in an admittedly crude fashion.

### The Dynamic Process

To trace the dynamic process embodied in the model, consider the effect of an increase in *F* brought about through a resource discovery, so that oil revenues do not necessarily rise immediately.^{14} If one abstracts from the accompanying leads and lags, the immediate confidence effect of higher expected wealth directly increases demand for real balances and private consumption expenditures and also influences private investment. These in turn will generate opposing forces that exert both upward and downward pressures on the level of income and prices (as explained in the next paragraph), so that the final outcome cannot be established a priori and needs to be determined empirically.

Initially, the higher demand for money will widen the real balance gap *(EFD)*, since μ < 1. This effect will depress the prices of nontraded goods^{15} and, hence, both imports and domestic inflation. The larger monetary disequilibrium will also dampen private demand for consumer goods and depress the growth of non-oil income. The excess of demand for non-oil commodities over potential output will then decline, further depressing nontraded goods prices and domestic inflation.^{16}

Thus, through its impact on demand for real balances alone, an increase in expected real oil wealth would eventually lead to lower domestic inflation and income; it is also likely to lead to an improvement in the current account of the balance of payments because imports decline while exports remain unchanged. The overall balance of payments may also improve if capital outflows—which result, according to equation (13), from a decline in income growth—are not too large.

These results do not, however, constitute the final outcome of an increase in *F*, because the larger *F* also stimulates private demand for goods and services *(con ^{d})*. Consequently, aggregate demand

*(y*rises relative to supply, putting upward pressure on the prices of nontraded goods and dampening the demand for real balances. A lower monetary disequilibrium will then result that will help to weaken or offset the feedback effects generated through the initial impact of the larger expected oil wealth on demand for real balances.

^{d})The net effect of these forces on the prices of nontraded goods will change relative prices. Given the fixed exchange rate, a decline (increase) in the prices of nontraded goods while the level of traded goods prices remains unchanged will result in reduced (increased) demand for imports. Any change in relative prices will also have an impact on domestic output, the direction of which is ambiguous a priori (as discussed earlier). The net result will feed into the dynamic system described above, strengthening or weakening some of the feedback effects. The final outcome of the movements in the variables depends on leads and lags (which were ignored in the discussion above) as well as on the relative speeds of adjustment and the strength of impact multipliers. These factors also determine the stability characteristics of the system. The eventual outcome for non-oil income, public and private expenditures, and imports will determine GDP and non-oil exports. The capital account as well as the overall balance of payments outcome will then be established, and the level of credit to the private sector will be determined by the money supply identity.^{17}

The distinguishing characteristic of the dynamic process embodied in this model can best be seen with respect to the impact of an increase in oil production (rather than in oil wealth). In contrast to the earlier work on oil producing countries, where an increase in oil production usually leads to a rise in prices and non-oil output, in the present model the impact of an increase in oil production on prices and on non-oil output is ambiguous. The expansion of oil output results in lower availability of the resource (that is, in a smaller *S*), and thereby in smaller expected oil wealth *F*. This outcome will tend to depress domestic output and prices, provided that the impact of the oil wealth effect on private expenditures is stronger than its impact on demand for money, as discussed above.^{18} In contrast, the expansion in oil revenues arising from the larger output will raise government expenditures, which may serve to reverse this trend. The overall impact is therefore not clear a priori.

## II. Estimation Results

The definition of variables and the complete model are presented, respectively, in Tables 1 and 2 above. The behavioral relationships of the model were estimated by a two-stage least-squares method using annual data for the period 1965-81.^{19} To ensure that cross-equation restrictions on the parameters of the money demand equation were satisfied, the variable *(M/P) ^{d}* was replaced by the antilog of

in all estimating equations, where *m* is the predicted value of *m* obtained from the estimated demand for money equation.^{20} Similarly, the unobservable variable *con ^{d}* is formulated from the estimated private consumption equation using the relationship

where b_{5} is the estimated coefficient of *con _{t-1}*. This variable was then used to calculate demand for domestic non-oil output

*(y*and for private expenditures (e). A dummy variable

^{d})*(D)*was introduced in the capital flow equation to account for unexplained variations in capital flows in 1980/81.

The estimation results are presented in Table 3. On the basis of the usual statistical criteria, the model performs well. The explanatory power of the model’s equations is quite reasonable, and all coefficients have the expected signs. Moreover, of the 39 estimated coefficients, all but 8 are significant at more than the 90 percent confidence level, and half are significant at the 99 percent confidence level.^{21}

### The Confidence Effect of Oil Wealth

The estimation results clearly indicate the existence of an oil wealth effect on the behavior of the economic agents, an aspect that has been neglected in previous analyses of the economies of major oil producers. The variable *f* (or *F*) is highly significant in all the equations where it appears: those for the demand for money, private consumption, and private investment. As expected, both money demand and private consumption respond positively to changes in expected oil wealth. A 1 percent increase in the expected oil wealth, everything else remaining equal, eventually raises both the real demand for money and private consumption by 0.2 percent. Because demand for money is stimulated by resource availability, expansionary monetary policy would be less inflationary in the presence of the oil wealth effect than in its absence.

**Estimated Model**

*R*is the adjusted coefficient of determination; DW is the Durbin-YVatson statistic

^{2}*H*is the Durbin

*H*-statistics and SEE is the standard error of the estimate.

^{1}The domestic interest fare was deleted from this equation because it did not prove to he significant and its inclusion did not improve the standard error of the equation. Moreover, since bclivares have been stable in relation to the U.S. dollar for almost all of the estimation period, the expected exchange rate change has been assumed to be aero. The foreign interest rate was proxied by the three- month U.S. Treasury bill rate. Various formulations of actual and expected inflation were also included in this equation to reflect the opportunity cost of holding money instead of real assets but were dropped because their estimated coefficent was found invariably to carry the wrong sign, to be statistically insignificant, or to lead to unstable simulations. This does not necessarily imply, of course, that this opportunity cost of holding money is irrelevant to the money demand function in Venezuela only that the mechanism for its measurement is more complicated.

**Estimated Model**

item | Estimated Equation |
---|---|

Demand for real balances (equation (1))^{1} | $\begin{array}{c}m=\underset{(-4.712)}{8.362}+\underset{(4.457)}{1.228}y+\underset{(2.894)}{0.154}f-\underset{(-1.701)}{0.011}{i}_{f}+\underset{(2.021)}{0.327}{m}_{t-1}\\ \begin{array}{cc}\begin{array}{c}{\overline{R}}^{2}=0.992\end{array}& \begin{array}{cc}H=0.335& SEE=0.045\end{array}\end{array}\end{array}$ |

Real private consumption (equation (2)) | $\begin{array}{c}con=-\underset{(-2.784)}{0.632}+\underset{\left(4.866\right)}{0.229}y+\underset{\left(2.900\right)}{0.063}f-\underset{(-0.592)}{0.000001}EF{D}_{t-1}+\underset{\left(9.329\right)}{0.680}{con}_{t-1}\\ \begin{array}{cc}\begin{array}{c}{\overline{R}}^{2}=0.997\end{array}& \begin{array}{cc}H-1.183& SEE=0.019\end{array}\end{array}\end{array}$ |

Real private investment (equation (3)) | $\begin{array}{c}KF/P=-\underset{(-2.101)}{16459.4+}\underset{\left(4.248\right)}{1.071}(Y/P)-\underset{(-2.493)}{0.01}(F/P)-\underset{(-1.349)}{0.159}{(K/P)}_{t-1}-\underset{(-2.666)}{1125.76}q\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.924& DW=1.449\end{array}& SEE=1586.0\end{array}\end{array}$ |

Domestic inflation (equation (4)) | $\begin{array}{c}\mathrm{\Delta}p=\underset{\left(5.403\right)}{0.115}+\underset{\left(3.385\right)}{0.265}\mathrm{\Delta}{y}^{d}\underset{(-7.243)}{-0.410}\mathrm{\Delta}k\underset{(-0.967)}{-0.000001}\mathrm{\Delta}EFD\underset{\left(0.803\right)}{+0.034}\mathrm{\Delta}{p}^{t}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.966& DW={2.140}^{2}\end{array}& SEE=0.019\end{array}\end{array}$ |

Growth of non-oil income (equation (5)) | $\begin{array}{c}\mathrm{\Delta}y=\underset{(-2.052)}{+1.545}+\underset{(5.078)}{0.466}{y}^{d}+\underset{(0.882)}{0.017}({p}^{n}-{p}^{t})\underset{(-0.141)}{-0.000001}EF{D}_{t-1}-\underset{(-4.279)}{0.622}{y}_{t-1}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.795& DW=2.342\end{array}& SEE=0.02\end{array}\end{array}$ |

Imports (equation (8)) | $\begin{array}{c}im=\underset{(-8.639)}{-5.585}+\underset{\left(1.510\right)}{0.316}e+\underset{\left(6.102\right)}{0.835}g\underset{\left(13.859\right)}{+0.878(}{p}^{n}-{p}^{t})+\underset{\left(3.882\right)}{0.418}i{m}_{t-1}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.993& H=-0.562\end{array}& SEE=0.047\end{array}\end{array}$ |

Government domestic revenues (equation (10)) | $\begin{array}{c}dr=\underset{(-8.007)}{-8.608}\underset{(16.980)}{+1.605}y\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.954& DW={1.930}^{2}\end{array}& SEE=0.069\end{array}\end{array}$ |

Government expenditure (equation (11)) | $\begin{array}{c}g=\underset{(4.499)}{0.304gr}\underset{(10.099)}{+0.698}{g}_{t-1}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.976& H=0.158\end{array}& SEE=0.068\end{array}\end{array}$ |

Private capital flows (equation (13)) | $\begin{array}{c}PKI=-\underset{(-2.223)}{7121.360}+\underset{\left(3.073\right)}{1738.04(i}-{i}_{f})+\underset{(2.333)}{0.157}\mathrm{\Delta}GDP+\underset{(2.500)}{0.009\mathrm{\Delta}}YUS-\underset{(-10.733)}{27070.8D}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.919& DW={2.073}^{2}\end{array}& SEE=2920\end{array}\end{array}$ |

*R*is the adjusted coefficient of determination; DW is the Durbin-YVatson statistic

^{2}*H*is the Durbin

*H*-statistics and SEE is the standard error of the estimate.

^{1}The domestic interest fare was deleted from this equation because it did not prove to he significant and its inclusion did not improve the standard error of the equation. Moreover, since bclivares have been stable in relation to the U.S. dollar for almost all of the estimation period, the expected exchange rate change has been assumed to be aero. The foreign interest rate was proxied by the three- month U.S. Treasury bill rate. Various formulations of actual and expected inflation were also included in this equation to reflect the opportunity cost of holding money instead of real assets but were dropped because their estimated coefficent was found invariably to carry the wrong sign, to be statistically insignificant, or to lead to unstable simulations. This does not necessarily imply, of course, that this opportunity cost of holding money is irrelevant to the money demand function in Venezuela only that the mechanism for its measurement is more complicated.

**Estimated Model**

item | Estimated Equation |
---|---|

Demand for real balances (equation (1))^{1} | $\begin{array}{c}m=\underset{(-4.712)}{8.362}+\underset{(4.457)}{1.228}y+\underset{(2.894)}{0.154}f-\underset{(-1.701)}{0.011}{i}_{f}+\underset{(2.021)}{0.327}{m}_{t-1}\\ \begin{array}{cc}\begin{array}{c}{\overline{R}}^{2}=0.992\end{array}& \begin{array}{cc}H=0.335& SEE=0.045\end{array}\end{array}\end{array}$ |

Real private consumption (equation (2)) | $\begin{array}{c}con=-\underset{(-2.784)}{0.632}+\underset{\left(4.866\right)}{0.229}y+\underset{\left(2.900\right)}{0.063}f-\underset{(-0.592)}{0.000001}EF{D}_{t-1}+\underset{\left(9.329\right)}{0.680}{con}_{t-1}\\ \begin{array}{cc}\begin{array}{c}{\overline{R}}^{2}=0.997\end{array}& \begin{array}{cc}H-1.183& SEE=0.019\end{array}\end{array}\end{array}$ |

Real private investment (equation (3)) | $\begin{array}{c}KF/P=-\underset{(-2.101)}{16459.4+}\underset{\left(4.248\right)}{1.071}(Y/P)-\underset{(-2.493)}{0.01}(F/P)-\underset{(-1.349)}{0.159}{(K/P)}_{t-1}-\underset{(-2.666)}{1125.76}q\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.924& DW=1.449\end{array}& SEE=1586.0\end{array}\end{array}$ |

Domestic inflation (equation (4)) | $\begin{array}{c}\mathrm{\Delta}p=\underset{\left(5.403\right)}{0.115}+\underset{\left(3.385\right)}{0.265}\mathrm{\Delta}{y}^{d}\underset{(-7.243)}{-0.410}\mathrm{\Delta}k\underset{(-0.967)}{-0.000001}\mathrm{\Delta}EFD\underset{\left(0.803\right)}{+0.034}\mathrm{\Delta}{p}^{t}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.966& DW={2.140}^{2}\end{array}& SEE=0.019\end{array}\end{array}$ |

Growth of non-oil income (equation (5)) | $\begin{array}{c}\mathrm{\Delta}y=\underset{(-2.052)}{+1.545}+\underset{(5.078)}{0.466}{y}^{d}+\underset{(0.882)}{0.017}({p}^{n}-{p}^{t})\underset{(-0.141)}{-0.000001}EF{D}_{t-1}-\underset{(-4.279)}{0.622}{y}_{t-1}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.795& DW=2.342\end{array}& SEE=0.02\end{array}\end{array}$ |

Imports (equation (8)) | $\begin{array}{c}im=\underset{(-8.639)}{-5.585}+\underset{\left(1.510\right)}{0.316}e+\underset{\left(6.102\right)}{0.835}g\underset{\left(13.859\right)}{+0.878(}{p}^{n}-{p}^{t})+\underset{\left(3.882\right)}{0.418}i{m}_{t-1}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.993& H=-0.562\end{array}& SEE=0.047\end{array}\end{array}$ |

Government domestic revenues (equation (10)) | $\begin{array}{c}dr=\underset{(-8.007)}{-8.608}\underset{(16.980)}{+1.605}y\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.954& DW={1.930}^{2}\end{array}& SEE=0.069\end{array}\end{array}$ |

Government expenditure (equation (11)) | $\begin{array}{c}g=\underset{(4.499)}{0.304gr}\underset{(10.099)}{+0.698}{g}_{t-1}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.976& H=0.158\end{array}& SEE=0.068\end{array}\end{array}$ |

Private capital flows (equation (13)) | $\begin{array}{c}PKI=-\underset{(-2.223)}{7121.360}+\underset{\left(3.073\right)}{1738.04(i}-{i}_{f})+\underset{(2.333)}{0.157}\mathrm{\Delta}GDP+\underset{(2.500)}{0.009\mathrm{\Delta}}YUS-\underset{(-10.733)}{27070.8D}\\ \begin{array}{cc}\begin{array}{cc}{\overline{R}}^{2}=0.919& DW={2.073}^{2}\end{array}& SEE=2920\end{array}\end{array}$ |

*R*is the adjusted coefficient of determination; DW is the Durbin-YVatson statistic

^{2}*H*is the Durbin

*H*-statistics and SEE is the standard error of the estimate.

^{1}The domestic interest fare was deleted from this equation because it did not prove to he significant and its inclusion did not improve the standard error of the equation. Moreover, since bclivares have been stable in relation to the U.S. dollar for almost all of the estimation period, the expected exchange rate change has been assumed to be aero. The foreign interest rate was proxied by the three- month U.S. Treasury bill rate. Various formulations of actual and expected inflation were also included in this equation to reflect the opportunity cost of holding money instead of real assets but were dropped because their estimated coefficent was found invariably to carry the wrong sign, to be statistically insignificant, or to lead to unstable simulations. This does not necessarily imply, of course, that this opportunity cost of holding money is irrelevant to the money demand function in Venezuela only that the mechanism for its measurement is more complicated.

Expected oil wealth tends to have an adverse impact on private investment (since the parameter *u _{3}* is negative). As discussed earlier, this may reflect the competing nature of private and government investment expenditures as perceived by private entrepreneurs. The availability of petroleum resources reduces the private sector’s propensity to save and its demand for investment. As a result, the growth prospects of the economy would depend, to a larger extent than in other countries, on the activities of the government. This finding highlights the importance of the composition of government expenditure for the growth prospects of oil-based economies. Whether oil wealth will act as a stimulant or a barrier to economic growth in the long run depends on the government’s ability to take a leading role in expanding the productive capacity of the economy through appropriate expenditure policies and through appropriate incentive schemes for the private sector to help mitigate the adverse influence of oil wealth on private investment.

### Monetary Disequilibrium

The results indicate that monetary disequilibrium is not a significant variable in the determination of private expenditures. The implication of this result is that, given the financial structure of the economy, monetary disequilibrium probably affects the interest rate, the exchange rate (relative prices), or capital flows and that it influences expenditures, mainly indirectly, through prices; direct effects are insignificant. Thus, the role of credit policy would also be to influence the interest rate, the exchange rate, and capital flows, and, through them, expenditures.

### Demand for Money

The estimated results of the money demand equation indicate that the main determinants of money demand in Venezuela are non-oil income and expected oil wealth. Contrary to expectations, the influence of the foreign interest rate on Venezuela’s open economy is not highly significant (t-probability of the estimated coefficient is 0.89), and the long-run interest elasticity of money demand is not very large; a 1 percent increase in the foreign interest rates, everything else remaining unchanged, reduces the demand for real balances by 0.02 percent. As can be expected in an open economy, equation (1) reveals the rapid adjustment of the actual to the desired level of the real money stocks (μ = 0.67): 90 percent of all the adjustments occur in the first 24 months following a disturbance.^{22}

### Private Expenditures

The results show that real private consumption is also determined primarily by the income and wealth variables (*y* and *f* respectively). The influence of monetary disequilibrium on private consumption decisions seems to be negligible.^{23} The actual level of real private consumption exhibits substantial sluggishness in adjusting to the desired level; only 50 percent of the adjustment occurs in the first two periods after a disturbance.

In addition to expected oil wealth and non-oil income, as shown by the results the relative price of capital is also an important determinant of private investment demand. Because the interest rate enters the calculation of the relative price variable, it could be argued that private investment is sensitive to changes in the interest rate, so that the growth rate of the economy is also affected by movements in the rate of interest. The estimated coefficient of lagged capital stock does not turn out to be significant, pointing to the possibility that the positive effect arising from replacement investment is offset by the low speed of adjustment of actual investment to the desired level.

### Non-Oil Income

The estimated equation for the growth of non-oil income indicates that domestic output responds strongly to the disequilibrium in the home-goods market but is not significantly affected by monetary disequilibrium or the terms of trade.^{24} The results indicate, however, that an improvement in the relative price of nontraded goods could stimulate the supply of domestic non-oil output despite a shift in demand from domestic to imported commodities.

### Inflation

The rate of inflation is determined primarily by the level of disequilibrium in the commodity market, which is measured by the excess of demand over potential output (Table 3). The disequilibrium variable enters the equation through its components *y ^{d}* and

*k*, and its impact on the inflation rate cannot be easily quantified. As indicated by relevant elasticities, however, the rate of inflation is more responsive to supply rather than demand factors; a 1 percent increase in the growth of potential output, everything else remaining equal, reduces the rate of inflation by 0.41 percent, whereas the same increase in the growth of demand raises the inflation rate by 0.27 percent.

### Imports

The estimation result of the import equation indicates that government expenditure and relative prices are the main determinants of import demand. The elasticity of imports with respect to government expenditure is almost four times larger than that with respect to private expenditure, reflecting mainly the large import content of government outlays. The relative price elasticity of imports is estimated at 1.5, indicating that a 1 percent devaluation would reduce imports by 1.5 percent. However, the adjustment of actual imports to the desired level is very slow; the mean lag of adjustment (calculated as (1—*k _{5})/k_{5})* is shown to be 17 months.

### Government Expenditure and Revenues

The estimated equation for government expenditure indicates that the government’s budgetary policy has been formulated as if to aim at a balanced budget over the long term.^{25} It also shows that government expenditures are adjusted slowly in response to changes in revenues; no more than 30 percent of any difference between government revenues and expenditures can be corrected in any one period. Government domestic revenues are shown to be strongly responsive to non-oil income, which alone explains 95 percent of their variations. Inclusion of oil revenues as a separate explanatory variable in this equation did not improve explanatory power, and the variable did not turn out to be significant. To the extent that oil receipts have any indirect impact on domestic revenues, this effect is therefore likely to be captured by the non-oil income variable.

### Capital Flows

The estimated equation for capital flows indicates that private short-term capital flows respond strongly to interest rate differentials between Venezuela and the United States and to GDP growth in both Venezuela and the United States. If the interest rate differential widens by 1 percentage point in favor of domestic rates, short-term capital flows would grow by Bs 1,738 million. The growth of domestic output results in larger movements in capital flows than does growth of U.S. GDP. ^{26} A structural change in the behavior of capital flows seems to have occurred in 1980, as indicated by the strong statistical significance of the dummy variable.^{27}

The above discussion has focused on the direct impact of changes in explanatory variables on the dependent variables. It has ignored the feedback effects from the rest of the model implied by a simultaneous system. Because the model is nonlinear in variables, it cannot be solved to obtain the impact and dynamic multiplier effects of the exogenous variables on the endogenous variables. The model is therefore simulated to examine the effects of exogenous shocks and changes in policy variables.

## III. Simulation Results

To test its reliability in tracking the endogenous variables, the model was simulated over the sample period using the estimated coefficients, the actual values of the exogenous variables, and the lagged values generated by the model.^{28} Simulation results (presented in Chart 12 in the appendix) indicate that the model tracks the time path of the endogenous variables quite well. In almost all cases, the turning points are well captured by the simulated results. As shown in Table 4, correlation of the actual and simulated series of endogenous variables is quite high. The smallest correlation coefficient is obtained for the capital flow equation. Even in this case, however, the correlation is close to 0.9—quite impressive given the volatility of such flows.

**Correlation Between Actual and Simulated Values, 1966-81**

**Correlation Between Actual and Simulated Values, 1966-81**

Variable | Correlation |
---|---|

y | 0.985 |

con | 0.999 |

P | 0.996 |

m | 0.992 |

KF/P | 0.929 |

g | 0.989 |

dr | 0.959 |

im | 0.990 |

PKI | 0.909 |

**Correlation Between Actual and Simulated Values, 1966-81**

Variable | Correlation |
---|---|

y | 0.985 |

con | 0.999 |

P | 0.996 |

m | 0.992 |

KF/P | 0.929 |

g | 0.989 |

dr | 0.959 |

im | 0.990 |

PKI | 0.909 |

To quantify the impact of the wealth effect and of a change in oil prices, the following experiments were conducted. First, oil prices were assumed to increase by 25 percent in 1970 and to return to their historical level in the following year. This assumption implies that both oil revenues *(OR)* and expected oil wealth *(F)* increase by 25 percent in 1970 and 1971, respectively. In the rest of this section this experiment is referred to as the full oil price shock. In the two succeeding experiments, the impact of this type of disturbance was broken down into two separate components, the income effect and the confidence effect. First, oil revenues were allowed to increase by 25 percent in 1970, with the expected oil wealth remaining unchanged (referred to as the partial oil price shock). Although this is an unlikely possibility in practice,^{29} it serves to demonstrate the impact of an oil price hike on the economy as captured by earlier models of oil producing countries that concentrate on the income effect and exclude the expected wealth effect of such shocks. The final experiment attempts to record the latter effect, represented by the influence of a temporary increase in *F* that is not accompanied by a change in oil revenues (called the resource discovery shock).^{30}

The results of these experiments are reported in Charts 1-11, which record the difference between the values of endogenous variables after the shock and those before the shock, which were obtained from a control simulation. These differences are expressed in percentages, except in the case of inflation (*INF)*, relative prices *(P ^{n}/P^{t})*, capital flows

*(PKI)*, and the balance of payments

*(ΔR)*, for which the absolute difference between the values obtained from shock simulations and from the control simulation has been presented.

The results of the first two experiments clearly show that ignoring the wealth effect can have serious adverse implications for the design of economic policy in the face of disturbances. Consider the impact of various shocks on real private consumption expenditures. A temporary increase of 25 percent in the price of oil at an unchanged level of wealth effect (or partial oil price shock) would increase real private consumption by about 0.9 percent above the level consumption would have attained in the absence of the disturbance. This occurs within five periods following the shock (Chart 1). Thereafter the impact dissipates slowly, reflecting the sluggishness of the adjustment, but consumption remains slightly above the control level even ten years after the original shock.

The impact of a full oil price shock—that is, a price shock when its associated wealth effect is not neutralized—is much more substantial. Real private expenditures rise by more than 1.5 percent within two years and remain at a higher level than that resulting from a partial oil price shock. The steeper increase is attributable to the impact of the wealth effect on private consumption. This finding is confirmed by results of the third experiment, in which the shock consists of a resource discovery, so that only the oil wealth is increased (by 25 percent). This experiment also shows that the impact of a temporary increase in expected wealth, although substantial, tends to wear off rapidly and, unlike the impact of an increase in oil revenues, dissipates completely about ten years after the original shock.

The significance of the oil wealth effect is more pronounced in the case of its impact on private capital formation (Chart 2). Whereas changes in real private investment resulting from the partial oil price shock are almost imperceptible, those brought about by the full price shock are substantial. The wealth effect associated with the full price shock results in an immediate decline of about 4 percent in private real investment. This is corrected in the next period, however, because the growth of non-oil income-itself stimulated by the increase in expected oil wealth-compensates for the adverse impact of higher expected wealth on investment. For the rest of the simulation periods, the level of real private capital formation remains above the level it would have attained in the absence of the shock. The effects of two types of price shocks on non-oil income tend to converge as the influence of higher expected oil wealth dissipates, leading eventually to the same proportionate expansion in non-oil output (Chart 3).

**Impact of Exogenous Disturbances: Real Private Investment**

(In percentage deviation from control simulation)

Note: See note to Chart 1.**Impact of Exogenous Disturbances: Non-Oil Revenues**

(In percentage deviation from control simulation)

Note: See note to Chart 1.The confidence effect of the oil wealth influences primarily the behavior of the private sector. As a result, government expenditure responds in an almost identical manner irrespective of the nature of the oil price disturbance and is only slightly affected by the resource discovery shock (Chart 4). Both types of oil price shocks lead to a sharp expansion of about 5 percent in expenditure in the first period, followed thereafter by a slow adjustment toward the historical level. However, reflecting their responsiveness to non-oil income, government domestic revenues are affected differently by the two types of price shocks. Government revenues rise more substantially if the oil wealth effect is present than if it is not (Chart 5).

**Impact of Exogenous Disturbances: Government Expenditure**

(In percentage deviation from control simulation)

Note: See note to Chart 1.Reflecting the dominant influence of government expenditure on imports, a pattern similar to that of the former emerges for imports in the aftermath of exogenous disturbances (Chart 6). The time path of imports is also affected, however, by the impact of disturbances on relative prices. Because of the associated wealth effect, the full oil price shock causes a larger improvement in relative prices, in favor of nontraded goods, than does the partial oil price shock (Chart 7). This outcome reinforces the indirect influence of the wealth (or confidence) effect on imports, so that the initial difference between the effects of full and partial oil price shocks on imports is larger than the difference observed in the impact of these shocks on government expenditure. The time paths of imports resulting from the two types of shocks converge later, in line with the diminishing influence of the temporary increase in the wealth effect.

The oil price shocks have a sharp but ephemeral impact on capital flows (Chart 8).^{31} In the first period net inflows grow by almost Bs 530 million over the historical level in response to the full oil price shock, of which Bs 470 million is due to the income effect and the rest to the confidence effect (indicated by the partial price shock and the resource discovery shock, respectively). Thus, although the wealth effect has an appreciable impact on private capital flows, its impact is overshadowed by the influence of the growth in oil revenues (and hence in domestic GDP) on such flows.^{32} In the second period, net inflows decline as GDP growth slows down, and the impact of the shocks fades rapidly in the subsequent periods as GDP growth is restored to its historical level.^{33}

**Impact of Exogenous Disturbances: Government Revenues**

(In percentage deviation from control simulation)

Note: See note to Chart 1.**Impact of Exogenous Disturbances: Government Revenues**

(In percentage deviation from control simulation)

Note: See note to Chart 1.**Impact of Exogenous Disturbances: Relative Prices**

(In percentage deviation from control simulation)

Note: See note to Chart 1.**Impact of Exogenous Disturbances: Private Capital Flows**

(In percentage deviation from control simulation; in millions of bolivares)

Note: See note to Chart 1.**Impact of Exogenous Disturbances: Private Capital Flows**

(In percentage deviation from control simulation; in millions of bolivares)

Note: See note to Chart 1.**Impact of Exogenous Disturbances: Private Capital Flows**

(In percentage deviation from control simulation; in millions of bolivares)

Note: See note to Chart 1.These results imply that the failure to take the wealth effect of oil price hikes into account could lead to a substantial underestimation of their adverse effect on the balance of payments in the medium term. This conclusion is confirmed by the results obtained for the balance of payments under various external disturbances (Chart 9). In the first period, both types of price shocks result in an improvement in the balance of payments as oil exports increase, but the impact of the full oil price shock is more pronounced, owing mainly to the influence of the wealth effect on capital flows. This improvement is followed by a sharp deterioration in the balance of payments, reflecting the combined effects of the growth of imports, increase in capital outflows, and reduction in export revenues (from the level achieved immediately after the shock). Again, the wealth effect has a substantial impact that causes a deterioration in the balance of payments that is sharper under the full price shock than under the partial shock. Moreover, although under the partial shock the balance of payments improves during several succeeding periods, this is not the case under the full price shock. The demand effect of the temporary increase in expected oil wealth wears off slowly, thus helping to raise the level of absorption and resulting in a larger deterioration in the balance of payments.

**Impact of Exogenous Disturbances: Balance of Payments**

(Deviation from control simulation; in millions of bolivares)

Note: See note to Chart 1.The time paths of inflation *(INF)* in response to different types of oil price shocks are markedly distinct (Chart 10). Initially the rate of inflation rises in relation to the historical level as a result of either type of price shock, reflecting the dominance of demand effects associated with higher oil revenues. The increase is considerably steeper in the case of the full oil price shock, however, owing to the impact on private expenditure of the wealth effect associated with this type of disturbance. In the next period the supply effect of higher oil revenues becomes dominant, resulting in a decline in the inflation rate. Again the decline is steeper—and the inflation rate actually falls below the historical level—in the case of the full price shock as the wealth effect leads to a greater monetary disequilibrium, which, in turn, exerts a further dampening impact on domestic inflation. Eventually, as the impact of the higher expected oil wealth wears off, both types of shocks produce a similar trend in domestic prices, with the inflation rate remaining below the historical level.

The discussion so far has indicated that the presence of an oil wealth or confidence effect exacerbates the impact disturbances entail, they are likely to affect the balance of payments more substantially and bring about wider fluctuations in domestic prices than previously thought. Although the impact of oil price shocks on domestic price inflation would be eventually dampened by the wealth effect, an oil price hike could generate stronger inflationary pressures in the initial stages. Therefore, in periods of rising oil prices, achieving balance of payments equilibrium or price stability would pose more significant policy challenges than previously recognized.

**Impact of Exogenous Disturbances: Inflation**

(In percentage-point deviation from control simulation)

Note: See note to Chart 1.Although an analysis of the nature and adequacy of different policy responses that may be called for in the face of oil price shocks is beyond the scope of this paper, monetary policy implications are evident from the simulation results. The demand for real balances, and hence the level of monetary disequilibrium, shifts significantly as a result of the various shocks (Chart 11). Failure to account for the wealth or confidence effect of oil price shocks, however, leads to a serious underestimation of the shift in demand for real money balances; whereas the full oil price shock leads to an increase of more than 4 percent in the demand for money in the first period after the shock, the partial oil price shock causes an increase of no more than 1 percent. The magnitude of the shift in monetary disequilibrium, and that of the task confronting monetary policymakers, is thus substantially larger when the wealth effect of resource availability is taken into account. In addition to its implication for the magnitude of policy response, the wealth effect has significant implications for the timing of monetary policy. The results show, for instance, that failure to take the wealth effect into account may result in a gradualist policy in the face of shocks, with the magnitude of intervention increasing slowly and reaching its peak five to six years after the original shock. If the wealth effect is recognized, in contrast, the appropriate policy response would consist of a massive initial intervention which diminishes in intensity in subsequent periods.

**Impact of Exogenous Disturbances: Real Money Balances**

(In percentage deviation from control simulation)

Note: See note to Chart 1.## IV. Conclusions

The paper has examined the implications of the availability and exhaustibility of oil resources for the economy of Venezuela in the framework of a model that incorporated the concept of exhaustibility and specified the main channels through which the availability of the resource (and the flow of income generated by it) affects economic variables. The estimation and simulation results confirmed that the availability of the resource entails a confidence effect that influences the behavior of the private sector. It was also confirmed that this effect is transmitted through demand for real balances and private expenditures (consumption and investment).

The empirical results indicated that, through its impact on money demand, the confidence effect associated with the availability of oil eventually dampens the inflationary consequences of expansionary policy. The confidence effect, however, adversely influences private saving and investment, and it imparts more significance to the pattern of government expenditure—as opposed to its level—in the oil producing countries compared with other developing countries. This implies that the growth prospects of the economy would depend on the ability of the government, which is the recipient of oil revenues, to embark on adequately productive projects that compensate for the adverse effect of expected oil wealth on the willingness of the private sector to undertake investment and that prepare the country for the eventual depletion of oil resources. A further implication is that private investment would need to be encouraged through incentive schemes that compensate for the adverse influence of oil wealth.

The speed of adjustment in money demand was found to be rapid, whereas that in the real sector tended to be sluggish, implying that changes in monetary disequilibrium are transmitted to the rest of the economy more quickly than are movements in the level of disequilibrium in the goods market. The authorities may thus have more time in containing the impact of real shocks to the economy than they will have in containing the consequences of financial disturbances.

The simulation results also showed that the impact of an increase in oil prices on the economy can be substantially more pronounced in the presence of an oil wealth effect than in its absence. In particular, failure to take the confidence effect of resource availability into account could lead to serious underestimation of the adverse influence of an oil price hike on the balance of payments and inflation. Moreover, it was shown that, eventually, the wealth effect tends to dampen the inflationary impact of rising oil prices, but it continues to exacerbate the adverse impact of such developments on the balance of payments. Thus, a major policy challenge facing the authorities during periods of rising oil prices would be that of devising a response that reconciles the dual objectives of balance of payments equilibrium and price stability. Moreover, in designing their policies in the face of disturbances, the authorities would have to keep in mind not only the nature of the shock but also the extent of the wealth effect associated with the country’s petroleum resources.

Although the nature and effectiveness of various policy responses that could be initiated to achieve balance of payments equilibrium and price stability in the aftermath of exogenous shocks were not discussed, the simulation results indicated that, at least in the case of monetary policy, the magnitude of the required response is substantially larger if the wealth effect is taken into account. It was also shown that the timing of intervention could be critical to the success of any monetary policy initiative. To devise an appropriate policy response, the authorities would need to know the time paths of the target variables that are likely to emerge both as a consequence of exogenous disturbances and in response to a policy intervention. Experiments similar to those conducted in this paper could serve to shed some light on these outcomes.

Although the model performed well in terms of the usual statistical criteria, the policy implications mentioned above need to be interpreted cautiously, primarily because of the small size of the sample and the large number of exogenous variables. In addition, the model needs to be modified slightly to account for the changes in the exchange system of Venezuela that have occurred since early 1983, so that its relevance and robustness could be tested against the developments in the Venezuelan economy during the post-sample period. For example, the model could be rendered more appropriate for policymaking purposes by endogenizing such important variables as the behavior of banks, represented by the excess reserves ratio, and the behavior of the private sector, such as the cash deposit ratio. The model could also be extended to incorporate more explicitly other policy variables, such as the exchange rate.

## APPENDIX Data Sources and Simulation Results

All the data used in the study, except for those mentioned below, have been obtained from the International Monetary Fund’s *International Financial Statistics* (Washington, various issues).

The index of traded goods price *(p ^{t})* was calculated as the weighted average of trading partners’ export prices, adjusted for the exchange rate. The countries and weights used were the following: United States (0.33), Netherlands Antilles (0.14), Canada (0.08), Japan (0.06), Italy (0.06), Brazil (0.04), Germany (0.03), other (0.26).

The level of oil production *(OP)* and the stock of oil reserves *(S)* in 1982 were obtained from various issues of the *Petroleum Economist* (London). The stock of oil for other periods was obtained as

Domestic oil consumption *(DOC)* was obtained from various IMF reports on Venezuela.

The following variables were derived residually:

non-oil GDP. *Y*:

*Y=GDP*-oil exports-domestic consumption of oil *(DOC);*

private expenditures, *E*:

**Dynamic Simulations**

(In millions of bolivares unless noted otherwise)

**Dynamic Simulations**

(In millions of bolivares unless noted otherwise)

**Dynamic Simulations**

(In millions of bolivares unless noted otherwise)

**Dynamic Simulations**

(In millions of bolivares unless noted otherwise)

**Dynamic Simulations**

(In millions of bolivares unless noted otherwise)

private capital inflows (net), *PKI*:

domestic government revenues, *DR*:

The dummy variable (D) was set equal to unity for 1980 and 1981 and equal to zero otherwise. Domestic and foreign interest rates were measured by the rate offered on one-year deposits in Venezuela and by the three-month U.S. Treasury bill rate, respectively.

Simulation results, discussed in Section III of the text, are presented graphically in Chart 12, panels A-J.

## References

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, Vol. 13 (January 1977), pp. 37–57.*Journal of Development Studies*Aghevli, Bijan B, and Cyrus Sassanpour, “Prices, Output and Trade Balance in Iran,”

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, Vol. 19 (March 1981), pp. 65–73.*Journal of Economic Literature*Eastwood, R.K., and A.J. Venables, “The Macroeconomic Implications of a Resource Discovery in an Open Economy,”

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(Amsterdam: North-Holland, 1966).*Commercial Bank Behavior and Economic Activity: A Structural Study of Monetary Policy in the United States*Hamburger, Michael J., “The Demand for Money in an Open Economy: Germany and the United Kingdom,”

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, Vol. 21 (July 1974), pp. 389–413.*Staff Papers*, International Monetary FundKhan, Mohsin S., “A Monetary Model of Balance of Payments: The Case of Venezuela,”

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*in*, ed. by Moshe Syrquin, Lance Taylor, and Larry E. Westphal (Orlando: Academic Press, 1984).*Economic Structure and Performance*McKenzie, G., and S.M. Schadler, “Exchange Rate Policies and Diversification in Oil-Exporting Countries” (unpublished; Washington: International Monetary Fund, 1980).

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(New York: St. Martin’s Press. 1979).*Expenditure of Oil Revenue*Neary, J.P., and S. van Wijnbergen, “Can an Oil Discovery Lead to a Recession? A Comment on Eastwood and Venables,”

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^{}*

This paper was published in *Staff Papers*, International Monetary Fund, Vol. 36 (June 1989), pp. 343-84. The views expressed are the author’s and do not necessarily represent those of the IMF.

^{}1

For a detailed discussion of other characteristics of oil producing developing countries, see Amuzegar (1983).

^{}2

Allowing for oil as an intermediate input may be tantamount to building an automatic Dutch disease process into the model, with the non-oil export sector being adversely affected whenever oil export prices increase. This procedure may. of course, be justified in some countries such as Canada. See Knight and Mathieson (1980).

^{}3

A fall in the relative price of the crop induces a shift to other profitable crops, whereas in oil exporting countries a switch to other exports that could adequately substitute for oil is clearly not feasible in the short run (see Lewis (1984)).

^{}4

If the country is small, so that its import supply function is elastic, and if domestic and foreign goods are perfect substitutes and no import restrictions exist, it makes no difference whether the government initially spends oil revenues on domestic or on foreign goods and services. Rather than influencing domestic prices, any excess liquidity created through government operations will initially leak out through imports. See McKenzie and Schadler (1980).

^{}5

Because oil income accrues to the government, its impact on money demand (and other private demand variables) works indirectly through the government expenditure function. Thus, oil income has not been included as an independent variable in money demand and private expenditure equations.

^{}6

Some studies (for example, Sundararajan and Thakur (1980)) have postulated an increasing relationship between the speed of adjustment (*u*) and the availability of resources for private capital formation. The variable for availability, measured by the difference between aggregate savings and government investment, was not found to be a significant factor determining private investment in Venezuela.

^{}7

The possibility that the divergence of relative prices from their long-run equilibrium value could also influence nontraded goods prices was excluded from the price equation, since empirical tests showed that this divergence was not significant.

^{}8

Non-oil exports accounted for no more than 5 percent of total exports in Venezuela during the sample period.

^{}9

If assets are perfectly substitutable, net capital flows will be indeterminate, and the estimates obtained from this equation cannot be interpreted meaningfully.

^{}10

It is assumed that government foreign receipts equal oil export receipts plus net foreign borrowing.

^{}11

This difference between the two stocks can be viewed as the “flow” demand for real balances; see Sundararajan (1986).

^{}12

The theory from which these decision rules are derived assumes, among other things, a monopolistic market structure, no binding technological constraints, and full information—none of which may hold in practice. In addition, the decision rules will be more complicated because the rate of return on financial assets may itself be affected by the variations in the price of oil. Given these considerations, the simplifying assumption in the text may be somewhat unrealistic.

^{}13

This assumption can be justified on the grounds that, in a market economy, the most obvious indicator of time preference is the rate of interest. In other words, the interest rate is supposed to adjust until it simultaneously equates the rate of time preference of the marginal individual in the society and the rate of return on productive investment.

^{}14

Oil revenues *(OR)* rise if the extraction rate or the price of oil increases. A resource discovery does not necessarily lead to either of these developments.

^{}15

More precisely, the larger real balance gap will reduce the rate of change in nontraded goods prices compared with what that rate would have been in the absence of a change in the real balance gap.

^{}16

The ensuing feedback effects will be strengthened or weakened depending on whether private investment is stimulated or depressed by a rise in F; that is, whether *μ _{3}* in equation (3) is positive or negative.

^{}17

Although the starting point of the above discussion is the effect of a change in *F*, the subsequent argument could be applied to changes in any other variable of the model. Clearly, however, the sequence of events as well as the final outcome will vary according to the nature of the original change. The feedback effects of movements in money supply and capital flows fall on credit to the private sector. Although the exchange rate variable does not enter the model explicitly, the impact of changes in this variable can be analyzed in a similar way. Because a change in the exchange rate affects oil revenues and prices of traded goods instantaneously, its impact on endogenous variables is equivalent to the combined effect of changes in these variables.

^{}19

Data sources are given in the appendix. The consumer price index *P* has been used as the deflator except in the case of imports, for which an index of traded goods prices—calculated from partner country data—has been used. A systems estimation method, such as full information maximum likelihood (FIML), would have been preferable for reducing the simultaneous equation bias and to ensure that the a priori restrictions on parameters were satisfied. Such a method, however, could result in large specification errors, especially for small samples.

^{}21

These results should be interpreted with caution because, for small samples, the properties of the probability distribution of coefficients estimated by the two-stage least-squares method are not well known. Goldfeld (1966)) believes that this procedure tends to produce conservative *t*-statistics.

^{}22

Adjustment over *T* periods is calculated as

^{}23

A variable that does not appear to be significant in a particular equation could, however, be significant in the context of the model as a whole, and its omission could result in appreciable changes in other coefficients of the model.

^{}24

The coefficients of *y ^{d}* and

*y*(the variables that constitute the components of excess demand in the goods market) are significant at the 1 percent level in equation (4). The results for this equation, as well as for those for domestic inflation, are quite reasonable in view of the fact that these equations are estimated in the first-difference form: even if original errors are independent, negative correlation could be introduced in first-difference equations, rendering both the standard error of the coefficients and the R

_{t-1}^{2}biased.

^{}26

These results are in contrast to those obtained by Khan (1974), in which GDP growth in either country was not found to be a significant factor affecting capital movements in Venezuela.

^{}27

Given the wide fluctuations in these flows, the extent of the variations explained by the capital flow equation (92 percent) is quite impressive. The results of this equation are superior to those obtained by Khan (1974), both in terms of the explanatory power of the equation and the significance of the variables. This superiority could be attributable in part to Khan’s use of the change in U.S. interest rates as an explanatory variable instead of interest rate differentials, as in the present study.

^{}28

This procedure is called dynamic simulation. It provides a more rigorous test of model stability than static simulation because in static simulation actual values of the lagged endogenous variables are used, whereas in dynamic simulation errors can accumulate over time.

^{}29

A price hike always affects expected oil wealth, even if the price hike is accompanied by an equivalent expansion in oil output. In the latter case, expected oil wealth decreases in the period when output grows but remains unchanged in the subsequent periods(*F =∏ _{t-1}S_{t})*.

^{}30

Again, this is an unlikely scenario because it implies a temporary increase in *S*. It is examined here in an attempt to isolate the impact of oil wealth on the economy.

^{}31

The charts for capital flows (Chart 8) and the balance of payments (Chart 9) record the time path of the absolute (rather than percentage) difference between the shock simulations and the base run. This is necessary because these variables can be positive or negative during the sample period.

^{}33

Because oil is the dominant component of GDP in Venezuela, GDP grows rapidly in the first period as oil revenues increase. The second period witnesses a decline in GDP (compared with the historical trend) as oil revenues are restored to their original level. Thereafter, GDP growth reflects only the increase in non-oil output because oil income remains unchanged.