The Resource Boom and the Exchange Rate
A country discovers large natural gas reserves. Export revenue from gas is forecast to rise from 2% to 9% of GDP over five years. The currency floats. Already, the exchange rate has appreciated 18% against major trading partners. Manufacturing exports, which employ 400,000 people, have seen order books shrink 12% and margins fall. The central bank holds the cash rate at 1.5% because inflation is only 1.8%, below the 2–3% target. The government runs a small surplus and is under pressure to spend the gas revenue on infrastructure and tax cuts.
1. Explain the mechanism by which the gas boom affects the manufacturing sector and evaluate whether this is a problem requiring a policy response.
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Mechanism (Dutch disease): Higher gas exports raise demand for the domestic currency, appreciating the exchange rate. A stronger currency makes manufacturing exports more expensive in foreign currency and imports cheaper, so manufacturing loses competitiveness. Resources also shift toward the booming sector as capital and labour follow higher returns. The result is a contraction in tradable manufacturing even though the economy as a whole is richer.
Is it a problem?
- Arguments it is not: The appreciation reflects higher national income; the economy is specialising according to comparative advantage. Consumers benefit from cheaper imports. The manufacturing decline may be an efficient reallocation.
- Arguments it is: Manufacturing may generate spillovers (skills, technology, agglomeration) that are lost permanently. Sudden structural change imposes adjustment costs on 400,000 workers. If gas prices fall, the economy may be left with a shrunken tradable base and a volatile currency.
Judgement: The appreciation is a symptom of success, not failure. The case for intervention rests on externalities and adjustment costs, not on protecting manufacturing per se. Policy should focus on smoothing adjustment (retraining, regional support) and on saving part of the revenue in a sovereign fund to manage volatility, rather than trying to hold down the exchange rate.
2. The government proposes spending all gas revenue on tax cuts. Assess this against alternative uses, using fiscal policy reasoning.
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Tax cuts: Tax cuts raise disposable income and aggregate demand. With inflation at 1.8%, below target, some stimulus is defensible. But the economy is already receiving a large demand boost from the gas boom, and spending all revenue would amplify the appreciation and worsen Dutch disease. Tax cuts are also hard to reverse if gas prices fall.
Alternatives:
- Sovereign wealth fund: Saving revenue stabilises the economy, limits upward pressure on the exchange rate, and provides a buffer for future downturns. This is the strongest option on stabilisation grounds.
- Infrastructure: Raises productive capacity and can ease bottlenecks, but adds to demand in the short run and may worsen inflation if capacity is already stretched.
- Debt reduction: The government already runs a surplus, so this yields limited benefit.
Judgement: Spending all revenue on tax cuts is the weakest option because it is pro-cyclical and irreversible. A mix of a sovereign fund (to stabilise) and targeted infrastructure (to build capacity) is preferable. Tax cuts could be justified only if they were temporary and aimed at low-income households, and if inflation were clearly below target.