The monetary aspects of the Dutch disease

Abstract

This article examines two facts of resource-rich developing economies during resource booms: (i) appreciation and depreciation of the real exchange rate (RER), and (ii) central bank monetisation of fiscal deficits. Our monetary model demonstrates that changes in bank loans, domestic public debt, and monetisation account for RER dynamics, not resource rents. Resource rents finance two deficits: (i) the fiscal deficit, raising domestic prices, and (ii) the non-resource current account deficit, increasing supply through imports and lowering domestic prices, which offset each other with a net-zero effect on the RER. In contrast, Dutch disease models assume resource rents are spent on non-tradables instead of imports. The case of Trinidad and Tobago (1979-2022) supports the model’s prediction: monetisation, not oil rents, drives the RER. Empirical studies must control for the non-resource current account deficit and money-financed fiscal expenditures. Finally, the non-resource primary fiscal deficit must not exceed foreign borrowing and resource-based funding.