Economic Policy in Countries Prone to Temporary Trade Shocks

Abstract

Abstract The economies of many developing countries are ‘small’, ‘open’, and experience spasmodic external shocks. By ‘small’ we mean that the country is not able to influence its external terms of trade but must accept the prevailing world market prices for its imports and exports. By ‘open’ we mean that international trade forms a substantial component of GDP. In the past decade, economists have developed a model of how small open economies are affected by external shocks, the theory being termed ‘Dutch Disease’ (after the supposed effects of the discovery of natural gas in The Netherlands in the 1960s). We provide a brief summary of this in Section 2.1. However, this theory focuses upon the effects of a permanent change in the terms of trade, whereas the more relevant phenomenon for many developing countries is that of temporary trade booms and slumps which may last for only a few years. The extension of ‘Dutch Disease’ theory to temporary shocks is more recent; it forms the focus of the present review. The key elements of the theory are outlined in Section 2.2. Asymmetries between booms and slumps are discussed in 2.3. Section 3 considers government policies, and Section 4 describes three examples of temporary trade shocks, a coffee boom in Kenya and the oil shocks in Indonesia and Nigeria.