Temporary oil production, current account deterioration and the role of monetary and fiscal policy

Abstract

This paper extends the results presented by Harvie (1990) and Harvie and Maleka (1991), using a similar theoretical and simulation framework to analyse the macroeconomic adjustment processes arising for an economy experiencing a temporary period of oil production. Similar assumptions to those in the aforementioned papers, regarding actual oil production, permanent oil revenues and the net export/import of oil, as well as to developments in the price of that oil under alternative wage adjustment assumptions are made. Here, however, emphasis is placed on developments in the current account, as reflected in foreign asset stock movements, after oil production ceases, as well as on the role that monetary, fiscal or fiscal/monetary policy can play in influencing current-account developments during this same period. Both Harvie (1990) and Harvie and Maleka (1991) conclude that, after a period of temporary oil production, the current account is likely to deteriorate. It is the contention here that the authorities will be concerned with such a potential development, and in the role which fiscal and/or monetary policy can play in alleviating such an effect. The results presented suggest that, to improve the performance of the current account, irrespective of the wage adjustment mechanism operative, after oil production ceases, the major thrust of macroeconomic policy should operate through fiscal rather than monetary policy. However developments in non-oil output would be influenced by the wage adjustment mechanism. With wage indexation, a tight fiscal policy after oil production ceases leads to a higher level of non-oil output than in the no policy response case, or one where monetary policy alone is used. With no wage indexation, the use of monetary and/or fiscal policy leads to lower levels of non-oil output. Hence the extent of wage indexation is important for this latter variable. The use of fiscal policy also has the added benefit of contributing to a lower consumer price level, again irrespective of the operative wage adjustment mechanism. If the emphasis of policy operates through monetary policy this paper suggests that, irrespective of the wage adjustment mechanism, the current-account problem will be exacerbated since foreign assets stocks will be lower. In addition, non-oil output and consumer prices will be lower. Hence potentially important policy prescriptions regarding the operation of fiscal and/or monetary policy for an economy after a temporary period of oil production, can be derived from this paper.