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Corresponding author: Spatafora. We are greatly indebted to W. Brainard, P. Cashin, K. Hamada, T. Krueger, P. Levy, O. Linton, P. Mauro, W. Nordhaus, A. Rodriguez-Clare, C. Sims, T.N. Srinivasan, and World Bank seminar participants for many helpful comments.
Portions of the paper are based on research carried out for Word Bank Policy Research Working Paper No. 1410.
Reinhart and Wickham (1994) provide rigorous evidence that the reduction in commodity prices is mostly secular, and has been accompanied by an increase in their volatility.
Selected contributions are discussed below (Appendix V, available upon request, provides a full theoretical and empirical survey).
Defined as nominal oil prices deflated by U.S. producer prices.
Nominal oil prices rose from $2.70 in 1973 to $34.31 in 1981, and then fell back to $16.31 in 1989.
We do not proceed beyond 1989 to avoid the complications associated with the Gulf War.
For example, Barro and Sala-i-Martin (1995) find, in a cross-country growth regression, that an increase in the annual growth rate of the terms of trade by one standard deviation, amounting to 3.6 percentage points in the 1965-75 period, raises the growth rate of real per capita GDP by 0.4 percentage points.
There are exceptions. Morley (1992), in a panel analysis of LDC stabilization programs, and Etherington and Yainshet (1988), in a time-series analysis of the Ethiopian economy, find a significant link between the terms of trade and domestic capital formation. See also Warner (1994), discussed in footnote 36.
Corden and Neary (1982) and Corden (1984) provide excellent summaries. See also Wijnbergen (1984, 1984b) and Neary and Wijnbergen (1984). At its simplest, an increase in the relative price of exportables to importables exerts two effects. First, it increases aggregate wealth and hence demand for nontradables. This raises the price of nontradables relative to importables (and possibly exportables), drawing resources into the former and out of the latter— the spending effect. Second, the shock raises the value marginal product of factors in the exportable sector, drawing resources out of both importables and nontradables—the resource-movement effect. After the shock, importable output must decrease. In contrast, nontradable output could grow or shrink: the spending effect acts to raise it, the resource-movement effect to lower it.
See Sen (1994) for an overview. This large literature includes Obstfeld (1982a, 1982b, 1983), Dornbusch (1983), Svensson and Razin (1983), Persson and Svensson (1985), Bean (1986), Matsuyama (1987), Edwards (1989), Sen and Turnovsky (1989), Schmidt-Hebbel and Serven (1993), Backus (1993), and Backus, Kehoe, and Kidland (1994).
The two strands of the literature have been partially integrated in Bruno and Sachs (1982), Ostry and Reinhart (1992), and Gavin (1990, 1992), as well as in the large literature on open-economy real business cycle (RBC) models, e.g., Mendoza (1992). However, Bruno and Sachs and all the RBC models rely on numerical simulations; Ostry and Reinhart focus exclusively on consumption rather than production; and Gavin assumes that there is no aggregate investment, that either importables or nontradables are not produced domestically, and that the economy faces exogenously given terms of trade. In contrast, our model is analytically tractable, allows for aggregate investment, allows production of both importables and nontradables, and remains valid even when the economy can influence its terms of trade.
As is standard, this should be interpreted as stating that (i) agents attach a zero ex ante subjective probability to those random shocks which we later examine, including unanticipated changes in the terms of trade, and (ii) agents correctly forecast the future time paths of all variables, conditional on such shocks not occurring.
While internally consistent, such an assumption may seem suspicious, and may indeed prove misleading, if in fact agents repeatedly experience random shocks. See footnote 25.
We show below that this must hold for sufficiently low levels of inherited foreign debt.
This is weaker than requiring PPP to hold either for the set of all goods, or for the production-weighted set of tradables.
That is, the economy can influence its terms of trade through the volume of its natural-resource exports, but not through the volume of its net trade in importables.
Convex adjustment, or “installation,” costs capture the notion that conceiving, approving, and implementing a given investment project over a very short period of time is much more expensive than carrying it out gradually. Hence, it is in general optimal to smooth out over time any investment response to shocks. A related approach is the “gestation lag” or “time-to-build” formulation, which postulates that it is physically impossible to complete an investment project in less than some minimum time frame.
Adjustment costs can be viewed as “internal” or “external” to the investing firm. The former interpretation emphasizes organizational inertia and the difficulties of managing a rapidly growing firm; the latter focuses on capacity constraints among suppliers of capital goods. At the macroeconomic level, the two approaches are fundamentally equivalent.
The specific functional form in (5) is chosen because it allows an explicit derivation of the global dynamics.
We adopt the fiction of a representative consumer-producer for simplicity. Given the absence of market failures, there are several alternative (and equivalent) ways to decentralize the command optimum.
Gavin (1990) argues that this assumption is reasonable for most developing countries. It is surely closer to the truth than assuming that, say, Saudi Arabia’s debt is denominated in oil. The assumption that foreign debt is denominated in importables strengthens (weakens) the wealth effect of an increase in the terms of trade if net foreign assets are initially negative (positive). The determinants of the equilibrium denomination of debt contracts probably include both history and, as discussed in footnote 25, factors related to optimal risk diversification.
Since (9) can be rewritten as
If domestic residents repeatedly experience terms-of-trade shocks, one might expect them to seek insurance against such disturbances by selling shares in the exportable sector to foreign residents, in exchange for claims on foreign assets. Depending on the precise source of the shocks, and on the diversifiability of the shocks at the level of the world economy, the optimal hedging strategy might reduce, eliminate, or even reverse the wealth effects associated with changes in the terms of trade; see Backus (1993).
In practice, the oil exporters engaged in minimal international portfolio diversification before the oil-price shocks. Indeed, they largely nationalized their domestic oil sectors. The reasons appear to have been mainly ideological and political. Specifically, foreign ownership of domestic natural resources was seen as a relic of colonialism and imperialism. Linked to this, the oil exporters felt they could not obtain good returns while foreign companies were running their oil industry.
Throughout this paper, all discounting is at rate r, unless otherwise specified.
If all labor is in fact immobile, manufacturing output is also unaffected.
We assume that the depreciation rate is sufficiently low, so that the (monotonic) decline in net investment along the transition path is accompanied by a decline in gross investment. If the economy was not initially in stationary state, the sign of the last term also depends on the shape of the adjustment cost functions.
On the other hand, governments may be unwilling to countenance large-scale immigration.
In general, the wage rate relevant to immigration decisions presumably depends on the price of a consumption-weighted basket of importables and nontradables. The greater the weight which potential immigrants place on nontradables, and the greater the impact of a natural-resource boom on the relative price of nontradables, the smaller the response of immigration to the boom. In theory, a natural-resource boom may even induce net emigration, reinforcing any Dutch Disease. Empirically, this latter case does not seem relevant.
Sachs (1981) points out that “cement-carrying ships were trapped for months outside the inadequate port at Lagos, Nigeria, after the post-1973 boom in spending.”
To the extent that productivity shocks in the oil sector led to a fall in the terms of trade but an increase in wealth, this should if anything bias our results against the conclusions of the model.
Observed values for savings, the trade balance, and oil-sector value added are occasionally negative. Hence, we transform these variables into country-specific indices, and run the regressions in levels rather than logs.
The panel estimator assigns a relatively large weight to countries where either the sample terms-of-trade variance, or the trade ratio, is relatively large. By construction, the countries in our sample rely heavily on oil for their exports, so that the variability of their terms of trade is similar. Hence, more open economies receive a larger weight. Intuitively, in such countries the impact of terms-of-trade shocks is larger, and hence can be estimated more precisely.
Warner (1994) shows that private investment in Mexican nontradables did decline over 1981-85. This study also suggests that an important mechanism for the investment decline was the reduction in the price of nontradables relative to imported equipment, and that the terms-of-trade deterioration can explain most of the decrease in this relative price.
Similar results apply for the current account. This does not contradict the view that current-account surpluses from the oil-rich countries helped finance loans to the LDC and thereby triggered the debt crisis. The point is that this “petrodollars” story only applies in the shortrun. In the medium run, the time frame over which the model is estimated, the response of consumption and investment turns the surplus into a deficit.
Let σ= 1 (the case where σ ≠ 1 is discussed in the main text). If r > ρ, then consumption of importables (and spending on nontradables) grows without bound, which in turn implies that net foreign assets grow without bound. Hence, the country eventually begins to affect the world interest rate. If instead r < ρ, then the country runs its wealth down as far as it can. To avoid these difficulties, we set r = ρ. We could also obtain convergence to a stationary state by specifying a time-path for r that converges to ρ.
Throughout, we define a stationary state as an equilibrium in which all variables are constant, except possibly for natural-resource output and hence foreign debt.
Even if labor is mobile, importable investment is unaffected so long as the sectoral allocation of labor does not change the marginal product of importable capital. But in this case importable employment and output decrease.