ChainWhat it assumes · how to break it
Start
Oil or mineral prices rise sharply, causing a boom in the extraction industry of a developing country that also has a small manufacturing sector.
1
As a result, export earnings in foreign currency rise, and when they are converted the demand for the local currency increases, so it appreciates.
exchange rate appreciation
exchange rate appreciation
Best link to attack
Assumes: The extra foreign currency is converted and the exchange rate floats.
Assumes: The extra foreign currency is converted and the exchange rate floats.
But: The central bank can buy foreign currency to hold down the exchange rate, or the government can save the earnings abroad in a wealth fund.
2
This means manufactured exports and agricultural exports become less price competitive, while imported goods become cheaper for domestic buyers.
international competitiveness
international competitiveness
Assumes: Other exports and import-competing goods are price sensitive.
But: Firms with strong brands or quality advantages can keep sales despite the appreciation.
3
Consequently, labour and capital move out of manufacturing and agriculture into the booming commodity sector and into non-traded services such as construction.
Dutch disease · resource reallocation
Dutch disease · resource reallocation
Assumes: Resources move to where returns are highest.
But: Commodity extraction is capital-intensive and employs few people, so the movement of labour may be small.
4
Therefore, manufacturing shrinks and the economy becomes more dependent on a single commodity, the opposite of the diversification development needs.
deindustrialisation · primary product dependency
deindustrialisation · primary product dependency
Assumes: Manufacturing does not recover once the boom ends.
But: If the boom is short, manufacturing may recover, though lost skills and firms are slow to rebuild.
End
The structure of the economy shifts towards the commodity sector and away from manufacturing, making it less diversified.
Evaluation chain
- E1However, the appreciation that drives Dutch disease depends on the foreign currency earnings being converted and spent at home.
- E2If the government saves the windfall in foreign assets through a sovereign wealth fund, or the central bank builds up reserves, the extra currency stays abroad.
- E3As a result, the exchange rate rises much less and manufacturing keeps more of its competitiveness.
- E4So a commodity boom need not shrink manufacturing; the structural damage depends on how the government manages the windfall.
Another way to attack it: If the boom is short-lived, the currency falls back before manufacturing capacity is lost, so the change in structure is temporary.
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Questions this answers
- Assess the impact of a commodity boom on the structure of a developing economy.
- Explain what is meant by Dutch disease.
- Discuss whether natural resources are a blessing or a curse for developing countries.
Diagram
Currency market diagram: demand for the local currency shifts right and it appreciates. Sector shares of GDP before and after the boom are good evidence.
Reverse and related
Fall in commodity prices → currency depreciates and other exports regain competitiveness, though the economy suffers a sharp loss of income first.