Adjustment and Structural Change under Supply Shocks

Abstract

The resource boom effect and the input price effect of raw material price changes are analyzed within a two-period, two-sector (plus resource industry), open economy framework. Diagrammatic exposition is used to study the “Dutch disease”, and in particular the distinction between the short-term wealth effects (causing a real appreciation and a movement of variable factors from tradeable to nontradeable industries) and the long-run effects on total investment, its sectoral allocation and its finance by foreign borrowing. The framework further enables analysis of the different allocational effects of temporary versus permanent raw material price increases, when the two sectors differ in material use. The effects of changes in the world interest rate on factor allocation and foreign borrowing, and the allocational effects of government intervention in the case of temporary real wage rigidity are also discussed.

This paper is part of a project on Structural Adjustment in Open Economies, conducted with Jeffrey Sachs, at the National Bureau for Economic Research in Cambridge, MA and at the Falk Institute for Economic Research, Jerusalem. Financial support from the National Science Foundation and the Ford Foundation is gratefully acknowledged.