Author's Accepted Manuscript

Monetary policy and the ducth disease effect

in an oil exporting economy
Mohamed Tahar Benkhodja

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PII: S2110-7017(14)00011-0
DOI: 10.1016/j.inteco.2014.01.003
Reference: INTECO28

To appear in: International Economics

Cite this article as: Mohamed Tahar Benkhodja, Monetary policy and the
ducth disease effect in an oil exporting economy, International Economics,
10.1016/j.inteco.2014.01.003

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Monetary Policy and the Ducth Disease Effect in
an Oil Exporting Economy

Mohamed Tahar Benkhodja∗†

Université Lumière-Lyon II & GATE-LSE

Abstract
In this paper, we build a Multi-sector Dynamic Stochastic General Equilibrium
(DSGE) model to investigate the impact of both windfall (an increase in oil price)
and boom (an increase in oil resource) on an oil exporting economy. Our model is
built to see if the two oil shocks (windfall and boom) generate, in the same propor-
tion, a Dutch Disease effect. Our main findings show that the Dutch disease effect
under its two main mechanisms, namely spending effect and resource-movement ef-
fect, occurs only in the case of flexible wages and sticky prices, when exchange rate
is fixed. We also compare the source of fluctuations that leads to a strong effect in
term of de-industrialization. We conclude that the windfall leads to a stronger effect
than a boom. Finally, the choice of flexible exchange rate regime helps to improve
welfare.
Keywords: Monetary Policy; Dutch Disease; Oil Prices; Small Open Economy;
DSGE.
JEL classification: E52; F41; Q40.

1 Introduction
The Dutch Disease theory was developed after the Netherlands found large sources
of natural gas in the North Sea in the 1960’s. Large capital inflows, from increased
export revenues caused, demand for the Dutch florin to rise, which, in turn, led to an
appreciation of the Dutch exchange rate. This appreciation made it difficult for the
manufacturing sector to compete in international markets.
∗
Université Lyon 2. E-mail : [email protected]. Tel. : +33 (0) 4.37.37.65.77. Fax : +33
(0)4.37.37.60.24 École Normale Supérieure Lettres et Sciences Humaines GATE-CNRS. Bureau R130
15, Parvis René Descartes 69342 Lyon cedex 07 France.
†
I would like to thank Jean pierre Allegret, Alain Sand, Hafedh Bouakez, Ali Dib, Aurélien Eyquem,
Edmar de Almeida and all participants at GATE-CNRS seminar and International Conference on Envi-
ronment and Natural Resources Management in Developing and Transition Economies, the 34th Interna-
tional Association for Energy Economics, the 17th International Conference on Computing in Economics
and Finance and the 60th Congress of the French Economic Association for their helpful comments and
discussion. All remaining errors are mine.

1
 This theory has been the subject of abundant theoretical literature since the begin-
ning of the 80’s. It has been developed in a partial equilibrium framework and can be
presented in two forms: the spending effect and the resource movement effect. Both
effects lead to a decline of the manufacturing sector. This decline occurs because of the
fall of output in this sector. Indeed, if the oil supply is not perfectly inelastic, a rise of
oil price leads to an increase of the demand of labor and capital in the oil sector and
increases wages and capital return in this sector. If the production factors are mobile,
capital and labor will move from the manufacturing sector to the oil and services sectors
which will cause de-industrialization.
There are two main mechanisms by which the oil shocks affect the economic activity:
the spending effect and the resource-movement effect1 . These effects are the essential
components of the Dutch disease theory. The spending effect is caused by higher domes-
tic incomes due to the increased revenues coming from resource discovery or an increase
in oil prices. The higher incomes lead to increased expenditures on both tradable and
non-tradable goods. The price of tradable goods is determined in international markets,
so the increase in incomes in this small country has no effect on the tradable goods
price. However, prices of non-tradable goods are established in the domestic market and
consequently, would rise due to the increase in demand caused by the rise in income and
expenditures. The higher relative prices of non-tradable goods increase the relative prof-
itability of the non-tradable goods sector and, as a result, contract the tradable goods
sector (not including the boom sector) (Neary and Van Wijnbergen 1986, p.2).
The resource movement effect occurs if the booming sector shares domestic factors
of production with the other sectors of the economy. If so, then there is a tendency for
the price of the factors to be bid up which would further squeeze the tradable goods
sector. The boom increases the marginal product of factors initially employed in the
booming sector, and so draws (mobile) resources out of other sectors. Consequently,
there is a decline in the tradable goods sector whose producers would be unable to pay
the higher prices for factors of production. These producers are unable to compete for
the inputs and thereby prevent the manufacturers from purchasing all of the supplies
needed to maintain production levels. As a result, these producers decrease their output,
contracting the traded goods sector.
Two types of external shocks generate these effects: windfall and boom. Although
they are both positive external shocks, a windfall shock (a rise of price of natural re-
source) does not incur costs while a boom shock (an increase in the stock of oil resources)
does incur costs2 .
Recent studies like Sosunov and Zamulin (2007), Lartey (2008), Batt et al (2008),
Acosta et al (2009) and Lama and Medina (2010) have used DSGE models to assess the
impact of a positive external shock in the case of a small open economy. These articles
1
The main difference between these two effects is that the first one (the spending effect) describes
the inflationary outcome of an income shock which, in turn, causes an appreciation of the local currency
(because of the going up of the relative price), while the second one denotes the movement of production
factors from various sectors to the resource one due to higher marginal productivities.
2
The search for new resource and its extraction requires costs while the rise of price of oil not.

2
discuss the impact of a positive external shock as an increase of capital inflow (Lartey
(2008)), remittances (Acosta et al (2009)) or of commodity prices (Sosunov and Zamlin
(2007), Batt et al (2008) and Lama and Medina (2010)). These shocks are defined in the
literature of the Dutch disease as windfall shocks. A boom shock which requires costs
has not been studied. Indeed, none of these papers is directly concerned with the effect
of boom shocks and even less by a comparison between both sources of Dutch disease.
In addition, none of them assesses the role of monetary policy in each case. Finally, none
of these models directly analyze oil-exporting economies, which are the most vulnerable
to this type of shocks.
In this context, we build a small open oil-exporting economy model with four sectors
while the above-mentioned contributions build DSGE models with only tradable and
non-tradable sectors. In this paper we add an oil sector to better reflect the mechanisms
of the Dutch disease described in the literature by Corden and Neary (1982). The latter
assume that the economy is composed of three sectors: i) the booming sector: after the
discovery of a new resource or a technological progress in the commodity sector or a rise
of natural resource price; ii) the lagging sector: generally refers to the manufacturing
sector but can also refer to agriculture; iii) the non-tradable sector: includes services,
utilities, transportation, etc.
To investigate the impact of the two main sources of Dutch Disease namely the wind-
fall sector (an increase in oil prices) and the boom sector (an increase of oil resource)
in a general equilibrium framework, we develop a Multisecor Dynamic Stochastic Gen-
eral equilibrium (MDSGE) model with microeconomic foundations and price and wage
rigidities. The model is based on recent studies that have developed models for small
open economies (Dib (2008), Bouakez, Rebei and Vencatachellum (2008), Acosta, Lartey
and Mandelman (2009) and Lama and Medina (2010)). Drawing on these papers, we
assume that the economy is inhabited by households, oil producing firms, non-tradable
and tradable good producers, intermediate foreign goods importers, a central bank and
a government. We also assume, as in Bouakez et al (2008), that the domestic oil price
is given by a convex combination of the current world price expressed in local currency
and the last period’s domestic price. We adopt, finally, a Taylor-type monetary policy
rule where it is assumed that the monetary authority adjusts the short-term nominal
interest rate in response to fluctuations in CPI inflation and exchange rate3 .
The main finding is that the Dutch disease under both spending and resource move-
ment effects occurs in the case of: flexible prices and wages and flexible wages and sticky
prices, when exchange rate is fixed. In other cases, the simulations indicate that Dutch
3
The exchange rate is included in the Taylor rule following De Mello and Moccero (2007, 2009).
As said by these authors: “There is some controversy over whether or not the exchange rate should
enter the reaction function. But we have opted for including it, because there may be more complex
interactions between movements in the exchange rate and macroeconomic performance in the context
of emerging-market economies that are not captured in the conventional Taylor rule. A case in point
is “fear of floating” in countries that have resorted to exchange rate targeting for extended periods.
Exchange rate-augmented monetary reaction functions have been estimated by Ball (1999), Mishkin and
Savastano (2001), Minella et al. (2003), and Mohanty and Klau(2005), among others”.

3
disease effects do not arise when prices are sticky, wages and the exchange rate are flex-
ible; prices and wages are sticky whatever the objective of the central bank is. We also
compare the source of fluctuations that leads to a Dutch disease and we conclude that
the windfall leads to a stronger de-industrialization compared to a boom.
In this essay, it appears that the flexible exchange rate seems to be the best way to
avoid the Dutch disease both in the cases of a windfall and a boom, but also to improve
welfare compared to fixed exchange rate. In other words, it is preferable for a central
bank, in an oil exporting economy, to adopt inflation targeting regime to prevent the
impact of oil shocks.
The rest of the chapter is organized as follows. In Section 2, we present the details
of the model. Section 3 discusses the parameters calibration. Section 4 presents the
results. Section 5 measures the welfare effect of both windfall and boom under alternative
monetary policy rules. Section 6 concludes.

2 Small open oil exporting economy model

In this section, we model an oil exporting economy based on recent small open economy
models (Dib (2008), Acosta, Lartey and Mandelman (2009) and Lama and Medina
(2010)). We assume that the economy is inhabited by eight agents: households, oil
producing firm, non-tradable and tradable goods producers, an intermediate foreign
goods importer, a final good producer, a central bank and a government.
Households have access to international financial markets where they can buy or sell
foreign non-state contingent bonds. They can also revise their nominal wages à la Calvo
(1983) and Yun (1996). In both oil, tradable and final good sectors, each producer
operates under perfect competition, while in the non-tradable good and imports sectors,
there is a continuum of monopolistically-competitive firms. In these sectors, prices are
sticky à la Calvo (1983) and Yun (1996). The central bank follows a Taylor-type rule,
aimed at stabilizing the CPI inflation rate and changes in the nominal exchange rate.
2.1 Households
To model the household’s behavior, we assume that the economy contains a continuum
of households indexed by ι ∈ (0, 1) . Each of them supplies differenciated labor services
to the three production sectors, namely oil, tradable and non-tradable sectors. As in
Erceg, Henderson and Levin (2000), a representative labor aggregator (or ”employment
agency”) combines households’ hours in the same proportions as firms would choose
optimally. Thus, in each sector j, the demand curve for each type of labor is given by :

 −θ
Wj,t (ι)
hj,t (ι) = hj,t . (1)
Wj,t

with j = [o, T, nT ].

4
 variables ho,t , hT,t and hnT,t denote aggregate labor supplies to oil, tradable and
non-tradable sectors, respectively. θ > 1 denotes the constant elasticity of substitution
between different types of labor services, Wj,t (ι) is the wage rate set by the household ι
and Wo,t , WT,t and WnT,t are the aggregate wage index, or the unit cost of sales to the
oil, tradable and non-tradable sectors, respectively.
The aggregate wage index Wj,t in sector j is given by:

⎛1 ⎞ 1−θ
1

Wj,t = ⎝ Wj,t (ι)1−θ dι⎠ (2)
0

from (1) and (2), we consider Wj,t and hj,t as given.

Each household ι derives utility from consumption ct (ι) and disutility from labor
ht (ι) :
∞
U0 (ι) = E 0 β t u (ct (ι) , ht (ι)) , (3)
t=0

where β is the subjective discount factor (0 < β < 1), E0 is the conditional expectation
operator evaluated at time 0. The intantaneous utility function, u(.), is:

1 ht (ι)1+σ
u(.) = ct (ι)1−γ − , (4)
1−γ 1+σ
where the preference parameters are γ > 1 and σ > 0. The first parameter, γ, is
the inverse of the elasticity of intertemporal substitution of consumption and the second
parameter, σ, denotes the inverse of Frish labor supply elasticity. Aggregate labor supply,
ht (ι) ,depends on sector-specific labor supplies according to:

ht (ι) = ho,t (ι)αho hT,t (ι)αhT hnT,t (ι)αhnT , (5)

where ho,t (ι) , hT,t (ι) and hnT,t (ι) represent hours worked by the household ι at time
t in oil, tradable and non-tradable sectors, respectively. The parameters αho , αhT and
αhnT denote the elasticity of substitution of labor in the three sectors, where αho +
αhT + αhnT = 1.
Households have access to domestic and international financial markets. Each house-
hold enters period t with holdings of domestic bonds denominated in units of domestic
d (ι), and foreign bonds denominated in units of foreign currency, B f (ι).
currency, Bt−1 t−1
These bonds are not state contingent. This assumption is crucial. In oil exporting
economies, household’s consumption is not smooth4 and there is no international risk
4
Households can still smooth consumption through the accumulation of domestic and foreign assets,
but the main goal of this assumption is to model the dynamic of the current account which is very
important to explain the spending effect.

5
sharing. Also, since the dynamics of exchange rate and the current account play a cen-
tral role in explaning the spending effect, the assumption of incomplete international
financial markets is necessary.56
During period t, household ι pays a lump-sum tax, Γt (ι), to finance government
spendings, and sells or buys Btf (ι) for the price that depends on a country-specific
risk-premium and the world interest rate. Buying foreign bonds entails paying a risk
premium, κt , of which the functional form is borrowed from Dib (2008):
⎛ ⎞

f f
et Bt /Pt ⎠
κt = exp ⎝−φ , (6)
Pt Y t

where φ is the risk premium parameter, et denotes the nominal exchange rate defined

as the price of the foreign currency expressed in the domestic currency, Btf is the aver-
age stock of external nominal debt, which is positive if the domestic economy is a net
borrower or negative if the domestic economy is a net lender. Finally, Yt is the total real
GDP and Ptf is the foreign price index. This functional form ensures stationarity of the
model.7
Household ι in period t earns nominal wages, Wo,t (ι) , WT,t (ι) and WnT,t (ι) for its
labor supply, respectively to the oil, tradable and non-tradable good producers. It also
receives dividend payments from both non-tradable, DnT,t (ι), and import, DI,t (ι), sec-
tors so that Dt (ι) = DnT,t (ι)+DI,t (ι) and a factor payment of oil resources,
(ι) PO,t Ot ,
where PO,t is the nominal price of oil resource input Ot and
(ι) is the share of household
1
ι in oil resource payments with
(ι) dι = 1.
0

Finally, household ι accumulates ko,t (ι) , kT,t (ι) and knT,t (ι) units of capital stocks,
used in the oil, tradable and non-tradable sectors and receives nominal rentals Qo,t , QT,t
and QnT,t respectively. The evolution of capital stock in each sector is given by:

kj,t+1 (ι) = (1 − δ)kj,t (ι) + ij,t (ι) − Ψj (kj,t+1 (ι) , kj,t (ι)) , (7)

where δ is depreciation rate, common to all sectors (0 < δ < 1) and Ψj,t (kj,t+1 (ι), kj,t (ι))
 
is an adjustment cost paid by households and satisfies ψ j (0) = 0, ψ j (.) > 0 and ψ j (.) <
0. The functional form of Ψj (.) is taken from Ireland (2003):
5
In fact, one important implication of the incomplete markets framework is that it allows us to
characterize the dynamics of the current account. See, among others, Chari, Kehoe and MacGrattan
(2002), Benigno (2004) and Begnino and Theonissen (2006).
6
See Kollmann (1996), Schmitt-Grohé and Uribe (2003) and Corsetti and Pesenti (2005) for more
details about the implications of complete and incomplete international financial markets.
7
See Schmitt-Grohé and Uribe (2003) for alternative ways of ensuring stationary paths in a small
open economy.

6
  2
ψj kj,t+1 (ι)
Ψj,t (.) = − 1 kj,t (ι) . (8)
2 kj,t (ι)

The presence of the capital adjustment cost implies that, out of the steady state, the
price of newly installed capital differs from the price of investment goods, i.e. Tobin’s Q
differs from 1. This form also allows to have both total and marginal costs of adjusting
capital equal to zero in the steady state.
The expenditures and revenues presented above give us the following household’s
budget constraint:

Btd (ι) et Btf (ι) f

Pt (ct (ι) + it (ι)) + + f
 Bt−1
d
(ι) + et Bt−1 (ι) +
Rt R t κt

Qj,t kj,t (ι) + Wj,t hj,t (ι) +
(ι) PO,t Ot + Dt (ι) − Γt (ι) , (9)
j=o,T,nT j=o,T,nT

where Pt it (ι) = Po,t io,t (ι) + PT,t iT,t (ι) + PnT,t inT,t (ι) denotes total investment. Pt is
the consumption price index (CPI), defined below.
Given initial values, household ι chooses {ct (ι), ko,t+1 (ι), kT,t+1 (ι), knT,t+1 (ι), Bdt (ι)
and Bft (ι)}8 to maximize equation (3) subject to equations (7) , (8) and (9) and the no-
Ponzi game restriction.
2.1.1 Wage setting
Following Erceg et al. (2000) and Dib (2008), we suppose that wages are sticky à la
Calvo (1983) and Yun (1996). In each period, the constant probability of changing the
nominal wages is given by (1 − ϕj ). Therefore, in average, the wage remains unchanged
1
for 1−ϕ periods.
j
However, if household ι is not allowed to adjust its wage, it updates it according to
the following rule:
Wj,t = πWj,t−1 ,
where π > 1 is the long run average gross rate inflation.
For the production sectors j = o, T, nT , household ι chooses Wj,t (ι) to maximize:
 ∞

 s s
max Et βϕj (U (ct+s (ι) , ht+s (ι)) + λt+s π Wj,t+s (ι) hj,t+s (ι) /Pt+s ) , (10)
j,t (ι)
W s=0

subject to:
 −θ
π s Wj,t (ι)
hj,t+s (ι) = hj,t+s . (11)
Wj,t+s
8
Because wages are sticky, the choice of worked hours is related to the level of wages which follow a
calvo price decision.

7
 The first-order condition gives:

∞  s 
s
Et s=0 βϕj θ
λt+s hj,t+s Λj,t+s wj,t+s π −θs π θt+k
θ k=1
j,t (ι) =
w . (12)
θ−1 ∞  s 
s
θ θ−1
Et s=0 βϕj λt+s hj,t+s wj,t+s π s(1−θ) π t+k
k=1

j,t (ι)
W Wj,t+s
j,t (ι) =
Where w Pt and wj,t+s = Pt+s denote the real optimized wage and the real
h1+σ
wage in sector j respectively, and for each sector j, Λj,t = αj,t hj,t
t
λt .
The aggregate real wage index in sector j evolves according to:
 1−θ
1−θ wj,t−1 
(wj,t ) = ϕj π j,t )1−θ
+ 1 − ϕj ( w (13)
πt

where π is the long run average gross rate of inflation.

Finally, Rtf and π ft denoting respectively the foreign interest rate and the world
inflation rate, evolve exogenously according to the following AR(1) process:

log(Rtf ) = (1 − ρRf ) log(Rf ) + ρRf log(Rt−1

f
) + εRf ,t (14)

log(π ft ) = (1 − ρπf ) log(π f ) + ρπf log(π ft−1 ) + επf ,t (15)

where removing the time index denotes steady state values and εRf ,t and επf ,t are un-
correlated and normally distributed innovations with zero mean and standard deviations
σ Rf and σ πf respectively.

2.2 Oil sector

A single oil firm operates in a perfect competition market and combines capital, ko,t =
1 1
0 ko,t (ι) dι, labor, ho,t = 0 ho,t (ι) dι, and oil resource, Ot , to produce crude oil. Oil
f
output is totally exported abroad for the international price Po,t denominated in the
foreign currency.
The firm maximizes profits and solves the following problem:
 
f
max et Po,t Yo,t − Qo,t ko,t − Wo,t ho,t − PO,t Ot , (16)
ko,t ,ho,t ,Ot

f
where et Po,t Yo,t denotes total sale revenues in terms of domestic currency, subject to the
following production function:
β
Yo,t  ko,t
αo
ho,to Otθo , (17)

8
 f
where αo , β o and θo ∈ (0, 1) and αo + β o + θo = 1. Thus, given et , Po,t , Po,t , Qo,t , Wo,t and
PO,t , the oil producing firm chooses {ko,t , ho,t , Ot } to maximize (16) subject to (17).
f
Note that foreign oil’s price, Po,t , and oil resource, Ot , evolutions are given by the
following stochastic processes:

f f
log(Po,t ) = (1 − ρP f ) log(Pof ) + ρP f log(Po,t−1 ) + εP f ,t , (18)
o o o

log(Ot ) = (1 − ρO ) log(O) + ρO log(Ot−1 ) + εO,t , (19)

where Pof and O are steady state values of Po,t
f
and Ot , ρP f and ρO are the autocorrelation
o
coefficients, and εP f ,t and εO,t are uncorrelated and normally distributed innovations
o
with zero mean and standard deviations σ P f and σ O respectively.
o

2.3 Tradable sector

In this sector, the tradable good is a manufatured good. Again, tradable good producer
operates on perfect competition markets. The firm produces its tradable good using
capital, kT,t , labor, hT,t , and refined oil input9 , Yo,t
IT
. Their production function is given
by:
θT
αT β I
YT,t  kT,t T
hT,t Yo,tT , (20)
where αT , β T and θT ∈ (0, 1) and αT + β T + θT = 1.
Thus, given et , PT,t , Po,t , QT,t ,and WT,t , the tradable firm chooses {kT,t ,hT,t and YIo,t
T
}
to solve its maximization problem.
2.4 Non-tradable sector
In this sector, non-tradable good producers operate under monopolistic competition.
There is a continuum of firms indexed by i ∈ (0, 1) . Each firm i produces non-tradable
goods using the following production function:

αnT β InT θ nT
YnT,t (i)  knT,t nT
(i) hnT,t (i) Yo,t (i) , (21)

InT
where knT,t (i) , hnT,t (i) and Yo,t (i) are used by firms to produce the non-tradable
goods. Note also that αnT , β nT and θnT ∈ (0, 1) and αnT + β nT + θnT = 1.
 
InT
To maximize its profit, the producer i chooses KnT,t (i) , hnT,t (i) and Yo,t (i) and
sets its price, PnT,t (i) à la Calvo (1983) and Yun (1996). Following a stochastic time
dependent Calvo (1983) rule, the producer faces, in each period, a constant probability
of changing its price. This probability is given by (1 − φnT ) .Therefore, on average, the
non-tradable price remains unchanged for 1−φ1 periods. As in Yun (1996), if non-
nT
tradable good producers are not able to change their price, they index them to the
steady state CPI inflation rate.
9
See section 5 for more details about refined oil.

9
 The non-tradable firms’ maximization problem can be written as follow:

∞

max E0 [(βφnT )s λt+s DnT,t+s (i)/Pt+s ], (22)
knT,t (i),hnT,t (i),PnT,t (i)
s=0

subject to (21) and the following demand function:

 −ϑ
π s PnT,t (i)
YnT,t+s (i) = YnT,t+s , (23)
PnT,t+s

with DnT,t+s (i) the profit function:

DnT,t+s (i) = π s PnT,t (i) YnT,t+s (i)−QnT,t+s knT,t+s (i)−WnT,t+s hnT,t+s (i)−Po,t Yo,t
InT
(i) ,

where β s λt+s is the producer’s discount factor and λt+s the marginal utility of consump-
tion in period t + s.
The optimal pricing condition is given by :

∞

s
E0 (βφnT )s λt+s YnT,t+s pϑnT,t+s mcnT,t+s π −sϑ π ϑt+k
ϑ s=0 k=1
pnT,t (i) = ∞ , (24)
ϑ−1 s

s
ϑ−1
E0 (βφnT ) λt+s YnT,t+s pϑnT,t+s π s(1−ϑ) π t+k
s=0 k=1

P MC P (i)
where pnT,t+s = nT,t+s
Pt+s , mcnT,t+s =
nT,t+s
Pt+s , pnT,t (i) = nT,t
pt and π t+s = PPt+s
t
denote
respectively the relative price of non-tradable goods, the real marginal cost in the non-
tradable sector, the real optimized price for non-tradable goods and the CPI inflation
rate.
Note finally that the aggregate real non-tradable price index evolves according to:

 1−ϑ
1−ϑ pnT,t−1
(pnT,t ) = φnT π pnT,t )1−ϑ .
+ (1 − φnT ) ( (25)
πt

2.5 Import sector

The final good producer uses an imported-composite good, YI,t , purchased in a domestic
monopolistically competitive market. To produce YI,t , the firm uses differentiated goods,
YI,t (i) , that are produced by a continuum of domestic importers, indexed by i ∈ (0, 1),
using a homogeneous intermediate good produced abroad for the world price Ptf . The
differentiated goods are sold at price PI,t (i) subject to Calvo (1983) and Yun (1996)

10
contracts.10 Therefore, the importer faces, in each period, a constant probability (1 − φI )
of changing its price as in Calvo (1983). Following Yun (1996), we assume that if
importers are not able to change their price, they index them to the steady state CPI
inflation rate.
The maximization problem of importers can be written as follows:

∞
 
max E0 (βφI )s λt+s π s PI,t (i) − et+s Pt+s
f
YI,t+s (i) , (26)
PI,t (i) s=0

where YI,t+s (i) is chosen by firms to maximize their profit:

 −ϑ
π s PI,t (i)
YI,t+s (i) = YI,t+s . (27)
PI,t+s

The zero−profit condition gives the importer price index:

 1  1−ϑ
1

PI,t+s = π PI,t (i)

s 1−ϑ
di . (28)
0

Replacing (27) in (26), we get the optimal pricing condition:

∞
s

s
E0 (βφI ) λt+s YI,t+s pϑI,t+s mcI,t+s π −sϑ π ϑt+k
ϑ s=0 k=1
pI,t (i)= ∞ s , (29)
ϑ−1 s

E0 (βφI ) λt+s YI,t+s pϑI,t+s π s(1−ϑ) π ϑ−1
t+k
s=0 k=1

f
PI,t+s et Pt+s
where pI,t+s = Pt+s is the relative price of imports, mcI,t+s = Pt+s = st is the real
PI,t (i)
marginal cost which is equal to the real exchange rate, pI,t (i) = pt is the optimized
Pt+s
price in import sector and π t+s = Pt is the CPI inflation rate.
The aggregate real import price index evolves according to:

 1−ϑ
1−ϑ pI,t−1
(pI,t ) = φI π pI,t )1−ϑ ,
+ (1 − φI ) ( (30)
πt

2.6 Final good producer

We assume that the producer of the final good operates under perfect competition. It
d , which
uses the following CES technology that includes a fraction of tradable output, YT,t
10
Introducing price rigidities allows the deviation from the law of one price in the import sector,
leading to incomplete pass-through effects of exchange rate movements.

11
is domestically-used, the non-tradable output, YnT,t , and imports, YI,t :

 1 τ −1 1 τ −1 1 τ −1
 τ
τ −1
zt = χT YTd
τ τ τ
+ χnT YnT τ τ
+ χ I YI τ
, (31)

where τ > 0 denotes the elasticity of substitution between the fraction of tradable
output, the non-tradable output and imported goods and χT , χnT , χI represent the
shares of tradable, non-tradable and imported goods in the total expenditure of final
good, where χT + χnT
  + χI = 1. To maximize its profit, the final good producer chooses
d
YI,t , YT,t and YnT,t .
The maximization problem is:

max Pt zt − PI,t YI,t − PT,t YT,t

d
− PnT,t YnT,t ,
d ,Y
YI,t ,YT,t nT,t

subject to (31). Solving this problem, we get the following demand functions:

 −τ  −τ  −τ

PI,t d PT,t PnT,t
YI,t = χI zt , YT,t = χT zt , YnT,t = χnT zt . (32)
Pt Pt Pt

where Pt , PI,t , PT,t , PnT,t are given. Note also that the zero profit condition implies that
the price of the final good is given by:

  1
1−τ 1−τ 1−τ 1−τ
Pt = χI PI,t + χT PT,t + χnT PnT,t , (33)

Finally, the final good is split between total consumption and total investment so
that zt = ct + io,t + iT,t + inT,t .

2.7 Central Bank

It is assumed that the central bank adjusts the short-term nominal interest rate, Rt ,
in response to fluctuation in CPI inflation, π t , and exchange rate changes Δet . As in
Bouakez et al (2008), we use the following Taylor-type policy rule to close the model:
  π   
Rt t Δet
log = ζ π log + ζ e log . (34)
R π Δe

where π, Δe, and R are the steady state values of inflation (π t ) ,exchange rate (Δet )
and nominal interest rate (Rt ) respectively. The policy coefficients, ζ π and ζ e , measure
the central bank responses to deviation of (π t ) and (Δet ) from their steady state levels.
When ζ e = 0 and ζ π = ∞, the central bank responds only to inflation movements
(and the exchange rate regime is floating). When ζ π = 0 and ζ e = ∞ the central bank

12
manages its rate to respond only to exchange rate fluctuation (and the exchange rate
regime is fixed).

2.8 Government
In an oil exporting economy11 , the oil domestically used (refined oil), Yo,tI , is mostly

produced abroad. For this, we assume that the government, which is the owner of the oil
f
firm, buys it from the world market for the international price, Po,t , denominated in the
foreign currency. The refined oil is sold domestically to the tradable and non-tradable
firms at price Po,t which can be considered as the domestic fuel prices. The latter is
supposed to be subsidized by the government. For this purpose, we follow Bouakez et
al. (2008) and assume that the domestic oil price Po,t is a convex combination of the
current world price expressed in local currency and previous period domestic price. It is
given by:
f
Po,t = (1 − υ)Po,t−1 + υst Po,t , (35)
where υ ∈ (0, 1) ,
Thus, when υ = 1, there is no subsidy and the pass-through from the world oil price
is complete. However, when υ = 0, the domestic oil price is fully subsidized and there is
no pass-through. Thus, all domestic firms will buy oil at price Po,t .
Following this, the government’s budget constraint can be written as follow:

I f f I
Po,t Yo,t + et Po,t Yo,t + Γt = et Po,t Yo,t + Wo,t ho,t + Qo,t ko,t + PO,t Ot , (36)

where the left-hand side represents the government’s revenues that include lump-sum
I , and foreign, e P f Y ex , firms.
taxes, Γt , and receipts from selling oil to domestic, Po,t Yo,t t o,t o,t
The right-hand side represents the government spending and include payments of both
wages and capital returns (Wo,t ho,t + Qo,t ko,t ) in the oil sector and the amount of im-
f I .
ported refined oil, et Po,t Yo,t

2.9 Aggregation and Equilibrium

In a symmetric equilibrium, all households, importers and non-tradable good produc-
ers make the same decision. so that: ct (ι) = ct , ht (ι) = ht , ho,t (ι) = ho,t , hT,t (ι) =
hT,t , hnT,t (ι) = hnT,t , bt (ι) = bt , bft (ι) = bft , ko,t (ι) = ko,t , kT,t (ι) = kT,t , knT,t (ι) =
knT,t , wo,t (ι) = wo,t , wT,t (ι) = wT,t , wnT,t (ι) = wnT,t , DnT,t (ι) = DnT,t , DI,t (ι) =
InT InT
DI,t , i (ι) = i, YnT,t (i) = YnT,t , Yo,t (i) = Yo,t , pnT,t (i) = pnT,t , YI,t (i) = YI,t , pI,t (i) =
Bt f Btf
pI,t for all ι and i ∈ (0, 1) , where bt = Pt , bt = are the real net domestic and foreign
Ptf
currency bonds respectively. Thus, a symmetric equilibrium for this economy is com-
posed of an allocation {ct , it , io,t , iT,t , inT,t , Yo,t , YnT,t , YT,t , YIo,t , YIo,t T
, YIo,t
nT
, YdT , Yex
T ,
f ∞
YI,t , Yt , YnT,t , YT,t , zt , ko,t , kT,t , knT,t , ht , ho,t , hT,t , hnT,t , bt , κt , Λo,t , ΛT,t , ΛnT,t }t=0
va va

11
It’s the case of Algeria and other countries as Iran for example.

13
and a sequence of prices and co-state variables {wo,t , wT,t , wnT,t ,w o,t, w
T,t, w
nT,t, qo,t , qT,t ,
qnT,t , po,t , pT,t , pnT,t , pnT,t , pI,t , pI,t , pO,t , π t , π nT,t , π I,t , st , et , Rt , λt , mcnT,t , mcI,t }∞ t=0
satisfying households, oil, tradable and non-tradable first-order conditions, the aggre-
gate resources constraints, the monetary policy rules, the current account equation and
the stochastic processes {pfo,t ,Ot ,Rft ,YfT ,π ft }∞ t=0 of the shocks and the following market
clearing conditions bt = bt−1 = 0, bt = bt and: f f

I IT InT
Yo,t = Yo,t + Yo,t (37)

d ex
YT,t = YT,t + YT,t (38)
Finally, the home economy exports part of its tradable output. According to McCal-
lum and Nelson (1999) and Gertler, Gilchrist and Natalucci (2003), we assume that the
ex , is given by :
foreign demand for the tradable goods, YT,t
 −ωT
ex et PT,t f
YT,t = νT YT,t . (39)
Ptf

f
where the foreign production of tradable goods, YT,t ,is exogenous and evolves ac-
cording to the following stochastic processes:
f
log(YT,t ) = (1 − ρY f ) log(YTf ) + ρY f log(YT,t−1
f
) + εY f ,t (40)
T T T

where YTf > 0 is the steady-state values of YT,t

f
and ρY f the autoregressive coefficients
T
and εY f ,t the uncorrelated and normally distributed innovations with zero mean and
T
standard deviation σ Y f .
T

As in McCallum and Nelson (1999), we assume that the domestic economy’s exports
from an insignificant franction of foreigners’ consumption, and thus their weight in the
foreign economy’s aggregate price index is negligible.
The aggregate GDP is defined as:
va
Yt = pT,t YT,t va
+ pnT,t YnT,t + st pfo,t Yo,t , (41)
va , and Y va are the value-added output in tradable and non-tradable sectors
where YT,t nT,t
respectively. These variables are constructed by subtracting oil input as follows:12

IT
Yo,t
va
YT,t = YT,t − po,t , (42)
pT,t
12
As in Dib (2008), our model suppose that tradable and non-tradable firms use refined oil as material
inputs in their productions which is defined as gross output. Thus, value added output in each sector
can be constructed by substracting commodity inputs.

14
 InT
Yo,t
va
YnT,t = YnT,t − po,t . (43)
pnT,t
Combining the households’ budget constraint, the single period profit functions of
non-tradable good producing firms and foreign good importers, the first-order conditions
of the four sectors, and applying the market clearing conditions, we get the following
current account equation:

bft bft−1
= ex
+ pT,t YT,t + pfo,t Yo,t − pfo,t Yo,t
I
− YI,t . (44)
κt Rtf π ft
3 Calibration
The aim of this section is to assign values to the structural parameters of the model. The
calibration exercise consists usually to either borrow the parameters from the literature
on the economies of similar structure, or estimates them from time-series data for a
specific economy, or, as in many studies, a mix of both. Our parameters values are
taken, mostly, from the literature of DSGE models, and adapt them to characterize
an oil exporting economy13 . We also set the coefficients of correlation and standard
deviation of the stochastic processes using OLS estimation.
There are 36 structural parameters in the model {β, σ, γ, αho , αhT , αhnT , ψ o , ψ T ,
ψ nT , θ, φ, δ, υ, αo , β o , θo , αT , β T , θT , αnT , β nT , θnT , ϑ, φnT , φI , ϕo , ϕT , ϕnT , χT ,
χnT , χI , τ , ν T , ω T , ζ π , ζ e }. The subjective discount factor, β, is set at 0.99 which
implies an annual steady-state real interest rate of 4%. As in Bouakez et al (2008), Dib
(2008) and Lartey (2008) the inverse of the elasticity of the intertemporal substitution
of consumption γ is set at 2. Following Devereux et al (2006) among others, the inverse
of the elasticity of the intertemporal substitution of labor σ is set at 1. The capital
depreciation rate δ is set at 0.025. This value is common to the three sectors of production
(oil, tradable and non-tradable sectors).
The parameters (αo , β o , θo ) ,(αT , β T , θT ), and (αnT , β nT , θnT ), which are associated
with the shares of capital, labor and a fraction of oil output in the output of each sector,
are calibrated as in Macklem et al. (2000). We set the share of capital, αo , labor, β o ,
and oil resources, θo , in the production of oil to 0.41, 0.39 and 0.2 respectively. In the
sector of tradable goods, the share of capital, αT , labor, β T , and a fraction of oil output,
θT , are assigned values to 0.26, 0.63 and 0.11 respectively. We also set to 0.28, 0.66
and 0.06 the share of capital, αnT , labor, β nT , and a fraction of oil output, θnT , in the
production of non-tradable goods.
As in Dib (2008), we set the parameters that represent the degree of monopoly power
in the intermediate good market, θ, and the labor market, ϑ, equal to 6 and 8 respectively.
The steady-state price and wage markup are equal to 20% and 14% respectively. The
price elasticity of demand for imported, domestic tradable and non-tradable goods, τ ,
13
We calibrate the model to match some features of oil exporting economies. Of these, Canadian and
Algerian economies will be used to calibrate some parameters.

15
 Table 1: Calibration of structural parameters.
Description Parameters Values
Structural Parameters
Subject discount factor β 0.99
Labor elasticity of substitution ϑ 8
Intermediate good elasticity of substitution θ 6
The inverse of the elasticity of intertemp substi of cons γ 2
The inverse of the Frish wage elasticity of labour supply σ 1
Labor elasticity of substitution in the oil sector α ho 0.32
Labor elasticity of substitution in the tradable sector α hT 0.13
Labor elasticity of substitution in the non-tradable sector αhnT 0.55
Parameter measuring the risk premium φ 0.0015
The depreciation rate of capital δ 0.025
Share of capital in the production of oil αo 0.41
Share of labor in the production of oil βo 0.39
Share of oil resource in the production of oil θo 0.2
Share of capital in the production of tradable goods αT 0.26
Share of labor in the production of tradable goods βT 0.63
Share of oil input in the production of tradable goods θT 0.11
Share of capital in the production of non-tradable goods αnT 0.28
Share of labor in the production of non-tradable goods β nT 0.66
Share of oil input in the production of non-tradable goods θnT 0.06
Oil price rule parameter υ 0.3
Calvo wage parameter for the oil sector ϕo 0.65
Calvo wage parameter for the tradable sector ϕT 0.65
Calvo wage parameter for the non-tradable sector ϕnT 0.65
Capital adjustment cost parameter in oil sector ψo 3
Capital adjustment cost parameter in tradable sector ψT 3
Capital adjustment cost parameter in non-tradable sector ψ nT 3
Calvo price parameter in the non-tradable sector φnT 0.65
Calvo price parameter in the import sector φI 0.65
Elasticity of substitution between domestic and foreign goods τ 0.8
Share of imported goods in the final good χI 0.45
Share of tradable goods in the final good χT 0.2
Share of non-tradable goods in the final good χnT 0.35
Constant associated with the share of exports in home GDP νT 0.2
Elasticity of substitution between home and foreign goods ωT 0.8
Inflation coefficient in the monetary policy rule ζπ 0, ∞
Exchange rate coefficient in the monetary policy rule ζe ∞, 0
Steady-state values
Gross steady-state of domestic inflation π 1.0085
Gross steady-state of the foreign inflation πf 1.0070
Steady state domestic interest rate R 1.0185
Steady state foreign interest rate Rf 1.0158
16
is set at 0.8 as in Dib (2008). The share of imports, , χI , domestic tradable, χT , and
non-tradable goods, χnT , in the production of final goods are set equal to 0.45, 0.2 and
0.35 respectively. These values are chosen given that the value of the average ratio of
both imports and tradable good production14 to GDP of Algerian economy. The share
of non-tradable good is chosen by subtracting to the unit the previous values. We set
values of the labor elasticity of substitution to match the shares of wages in the three
sectors of the Algerian economy (oil, tradable and non-tradable), so that, αho , αhT and
αhnT are equal to 0.32, 0.13 and 0.55 respectively.15
As in the standard literature of DSGE models, we set the parameter of Calvo price
setting equal to 0.65 . Wage stickiness in the three sectors (oil, ϕo , tradable, ϕT , and
non-tradable, ϕnT , goods sectors) are set at the same level. We assume that this value
is the same across sectors (import, φI , and non-tradable sectors, φnT ). This means
that, on average, price adjustment occurs every 2.85 quarters. As in Lartey (2008) and
Devereux, Lane and Xu (2006), we set the capital adjustment cost equal to 3 in the
three sectors (oil, ψ o , tradable, ψ T , and non-tradable, ψ nT , sectors). The parameter in
the risk-premium terms φ is set equal to 0.0015. All of these parameters are listed in
Table 1.
Finally, Table 2 reports the results of different OLS estimations of the exogenous
stochastic processes. All parameters are statistically significant at the 5% level. Some
of these stochastic processes are highly persistent while others are not.

Table 2: Calibration of the stochastic parameters.

Shocks Autocorrelations Standard deviation
Foreign interest rate ρRf 0.9886 σ Rf 0.1693
Foreign tradable output ρY f 0.9676 σ Y f 0.1578
T T
Foreign inflation ρπf 0.9549 σ πf 0.1999
Foreign oil output ρY f 0.2582 σ Y f 0.0104
o o
Foreign oil price ρp f 0.2317 σ pf 0.1975
o o
Oil resources shock ρO 0.9899 σ O 0.2089

14
Since the Algerian economy exports an insignificant franction of tradable goods, the average ratio
of total tradable production to GDP could be assimilated by the value of the domestic use. This is the
case of many oil exporting countries.
15
These values are chosen by using ONS (national office of statistics) data.

17
4 Simulation analysis
In this section, we analyze the effect of an increase of one percent in the price of oil
(windfall) and oil resources (boom) on this economy. We attempt to verify if this increase
generates a Dutch disease effect in both resource movement and spending effects and
in which case the phenomenon of de-industrialization is the most important. Thus, we
try to disentangle the source of fluctuation, between the windfall and the boom, which
generates a Dutch disease effect. First, we conduct simulations under the hypothesis
of perfect wage and price flexibility. Then, we consider the impact of an oil shock
(price and resource) assuming that prices are sticky. Finally, we add the assumption
of wage rigidity. In the two last cases, we analyse the response of some key variables
under alternative monetary policy rules (fixed exchange rate rule (ER rule) and inflation
targeting rule (IT rule)). The response of our selected variables will be relative to that
of our baseline model. In these cases, this is the gap between both responses (baseline
and sticky price-sticky wage models) that will provide information on the occurrence of
the Dutch disease effect.
4.1 Flexible prices and wages setting
In the case of flexible prices and wages (baseline model), monetary policy plays no role.
Simulation results are shown in the figure 1 and 2 which present the reallocation process
experienced in the economy in response to an increase of one standard deviation of oil
price and oil resources. Figure 1 shows that an increase in the international price of
oil leads to a decline in the manufacturing sector.16 Indeed, the results show a decline
in all selected variables (production, capital, investment, wage and hours worked) in
the tradable good sector. This decrease is accompanied by a boom in the oil and non-
tradable sectors. Indeed, the impact on other sectors is quite large. As Figure 1 shows,
all variables, capital, investment and wage, for instance, respond positively to oil price
shock. This expansion in the oil sector is the result of the decline of manufacturing
industry whose wages and capital decline. Hence, labor demand is much greater in the
other sector (resource movement effect).
Figure 1 also shows an appreciation of the real exchange rate after the windflall.
This is due to export revenues due to the rise in oil price. This appreciation of exchange
rate seems to contribute partly to the decline of the manufacturing industry through a
decline in price competitiveness of the sector and, therefore, the decline of its exports.
This is similar to the spending effect.
After the boom (increase in oil resource), Figure 2 depicts an increase in wages,
and marginal product in the oil sector which leads to an increase in labor demand
and therefore a rise in the production of oil goods and a decline in the manufacturing
production. This second effect is defined as the resource movement effect. On the
other hand, Figure 2 shows an increase in the real exhange rate due to the rise of oil
price. Through the spending effect, the appreciation of the exchange rate has probably
contributed to the de-industrialization of the tradable goods sector.
16
These results are similar to those of Lama and Medina (2010) and Lartey (2008).

18
 5.4379in;cropleft ”0”;croptop ”1”;cropright ”1”;cropbottom ”0”;tempfilename
Through these results, we can see that in both cases, windfall and boom, the economy
undergoes de-industrialization because of both spending and resource movement effects.
To compare the importance of de-industrialization in each case, boom and windfall,
Figure 3 illustrates the impulse response functions of some key variables of the manu-
facturing sector facing an increase of one percent in oil prices and oil resources. Figure
3 shows that the decline in the manufacturing sector is much larger in the case of wind-
fall (oil price shock). Indeed, key variables, such as investment, production and wage
decrease more significantly in the case of a windfall than in the case of a boom. There-
fore, we conclude that, overall, Dutch disease effects are especially the consequence of a
windfall rather than a boom. This result could be explained by the fact that, an increase
in oil price (windfall) causes an instantaneous effect on oil sector revenues and then a
much more pressure on labor and capital demand, while an increase in oil production
(or oil discovery which is defined as a boom) could cause a less important reaction given
that the magnitude of the revenues is often less important in the case of a boom. Also,
the period between the date of discovery and the export of the new production could be
important and so the revenues generated by this production will be added later.
Thus, the question we answer is: what is the exchange rate regime that would avoid
the consequences of a windfall and/or of a boom? To do so, we jointly consider price
and wage rigidities.

4.2 Sticky price model

In the case of sticky prices, the choice of the exchange rate regime plays a central role
in the stabilization of the economy. We first simulate the impact of an increase in oil
prices (and oil resource) in the case of a fixed exchange rate regime (ζ e =∞), then we
simulate the impact of an increase in oil prices in the case of a flexible exchange rate
regime (ζ e =0) (and oil resource).
4.2.1 Fixed exchange rate
As in the first case, Figure 4 shows a decline in the manufacturing sector compared to the
other two sectors. Production of tradable goods, accumulation of capital and investment
in this sector all experience a decline, comparatively to the baseline model, due to the
increase in the oil price. In the two other sectors, the situation is different. This leads
to an instantaneous increase in the production in the oil sector, which generates a large
inflow of foreign currency. Unlike the baseline model, the windfall does not lead to an
appreciation of the real exchange rate. This response can be interpreted as the result
of the intervention of the central bank in the foreign exchange market to stabilize the
exchange rate. Therefore, we conclude that (i) the spending effect has not occurred and
(ii) the decline of the manufacturing sector only results from the resource movement
effect.
As Figure 4 shows, the de-industrialization of the economy seems to be the result of
the labor shift from the tradable sector toward the oil sector.
Hours worked respond more after the shock in the oil sector relative to the manufac-

19
turing sector. This is due to rising wages in the oil sector that create a greater demand
for labor in this sector. As a result, the production of the tradable sector declines.
In the case of a boom, Figure 5 also depicts a decline in the manufacturing sector
due to an increase in oil resources. The oil and non-tradable sectors experience a rise
in production and investment. As in the first case, the real exchange rate does not
react to the shock. This is due to the fact that the appreciation is absorbed by the
intervention of the monetary authority in the foreign exchange market. Therefore, the
de-industrialization of the manufacturing sector can not be the result of the spending
effect.
The resource movement effect is the most likely transmission channel. The increase
in production in the oil sector leads to a significant increase in both wages and hours
worked in this sector compared to the tradable sector.
Overall, we conclude that in the case of sticky prices and the fixed exchange rate,
a boom or a windfall in the oil sector generates the Dutch disease effect driven by the
resource movement effect.
4.2.2 Flexible exchange rate
Figure 6 and 7 show that Dutch disease effect does not occur in the case of both windfall
and boom under flexible exchange rate. Indeed, compared to the baseline model, the
tradable good sector does not witness a decline, even if the oil and non-tradable sectors
witness a boom following these two exogenous shocks.17
These results can be explained by the fact that inflation targeting prevents prices
and wages increase in both the oil and non-tradable sectors. Indeed, relatively to the
baseline model, wages in all sectors experienced stability after the oil shock The resource
movement effect is therefore avoided. So, flexibility of the exchange rate has not allowed
the occurrence of the Dutch disease under its spending effect. Figure 6 and 7 show that
the exchange rate appreciates in both cases (windfall and boom) but manufacturing
output does not decline. This can be attributed to the structure of the oil exporting
countries’ manufacturing sector which is characterized by a low level of industrialization
relative to developed countries. In other words, the spending effect is not operational
when the resource movement effect channel is locked. Therefore, exports of tradable
goods are not affected by fluctuations of real exchange rate.
One of the findings is that, in the case of an exogenous boom (either an increase in
oil prices or a rise in oil resources), the flexible exchange rate regime insulate from Dutch
disease effect to the extent that fluctuations of the real exchange rate is insufficient to
trigger the spending effect. This is, maybe, due to the structural characteristic of an oil
exporting economy whose manufacturing sector is not sufficiently competitive.
17
This result seems to contradict the conclusion reached by Corden and Neary (1982) and Lartey
(2008) who show that when monetary policy is designed to follow the flexible exchange rate rule, in the
case of sticky price, the manufacturing output decline in response to the shock.

20
4.3 Sticky price-wage model
In this section we assume that wages are sticky by setting ϕj = 0.65. In line with the
work of Hausmann and Rigobon (2002) among others, we check the validity of the results
obtained in the general equilibrium framework by comparing the results of a boom and
windfall. As in the previous section, we assume, firstly, that the central bank targets the
nominal exchange rate. Then, we compare the results to those obtained with a flexible
exchange rate.
4.3.1 Fixed exchange rate
In the case of a fixed nominal exchange rate, Figues 8 and 9 show an increase of both
oil prices and production in the oil sector. This increase is less important than in the
case of the baseline model. Also, manufacturing production does not decline implying
that Dutch disease effects are absent. Figure 9 shows that manufacturing production
increases and then slightly declines. The non-tradable and oil sectors follow a similar
pattern.
Thus, in the case where wages and prices are sticky and where the central bank targets
the nominal exchange rate, Dutch disease effect does not rise. The main reason is that
the spending effect channel neutralized by the monetary policy. Fluctuations of the
nominal exchange rate are contained by the monetary authority from the third quarter
in both cases (boom and windfall). Then, the resource movement effect, consisting in
a shift of labor and capital from the manufacturing sector toward both oil and/or non-
tradable sectors, is avoided because of sticky wages that does not allows the oil and
non-tradable sectors to become more attractive. Therefore, wages and prices stickness
together with fixed exchange rate completly offset Dutch disease effects.
4.3.2 Flexible exchange rate
In the last case where the exchange rate regime is flexible, Dutch disease effect does not
occurs although the spending effect seems to be operational. The manufacturing sector
does not decline both in the case of a windfall or a boom as shown by Figure 10 and 11.
Indeed, as in the case where only prices are sticky, exchange rate flexibility is not
sufficient to allow the realization of the spending effect. Thus, in both cases (fixed ex-
change rates and flexible exchange rates) prices and wages rigidity insulate the economy
from Dutch disease effects in the cases of either a windfall or a boom.
5 Welfare effects

In this section, we compare the impact of a windfall and a boom on the welfare under
alternative exchange rate regimes. We compute the welfare using the unconditional
expectation of the utility function. To do this, we use a second-order approximation of
the utility function around the deterministic steady state18 .
Formally, the welfare criterion is derived from the following single-period utility func-
18
For similar method see Schmitt-Grohé and Uribe (2004)

21
tion:
∞

E0 β t U (ct , ht ) , (45)
t=0

the second-order approximation result is given by:

 
1+σ
μ(.)  μ + c1−γ E(
ct ) − h E ht − (46)
     2 
γ 1−γ    σ
1+σ
c E var ( ct ) + E (ct ) 2
− h E var 
ht + E 
ht
2 2

where bars denote steady-state values and hats represent percentage deviations from
the steady-state. The welfare cost is measured by the compensating variation which
allows us to measure the percentage changes in consumption in the deterministic steady
state.
We calculate the welfare effects for the flexible price-and-wage model, sticky price
and sticky wage models under alternative exchange rate regimes both in the case of
windfall and boom.
Our main findings are summarized in Table 3.

Table 3: Welfare results (in percentage of the steady state of consumption).

Windfall Boom
Flexible price and wage model 0.0192 0.0099
Exchange rate regime Flexible Fixed Flexible Fixed
Sticky price model 0.0296 0.0226 0.0134 0.0173
Sticky price-wage model 0.0381 0.1563 0.0202 0.0334

Table 3 reports, in the flexible prices and wages model, that the welfare has a far
greater impact on welfare cost than the boom. Indeed, welfare cost associated with a
windfall is around 0.0192% of consumption in a deterministic steady-state, while with a
boom it is around 0.099%. This is due to the fact that the windfall, as shown in section
3, leads to a strong effect of Dutch disease in terms of de-industrialization compared to a
boom. Indeed, because of the fall of wages in the tradable sector (more important in the
case of windfall), the households purchasing power is more important in the aftermath
of a boom.
In the two other models (sticky price model and sticky price-wage model) the results
remain unchanged such that, the welfare cost is more important following a windfall
rather than a boom. Indeed, when the exchange rate regime is flexible, in the sticky
price model, the welfare cost is equal to 0.0296% and 0.0134% in the case of windfall
and boom respectively. In the case of sticky price-wage model, the welfare cost is equal
to 0.0381% and 0.0202% respectively after a windfall and a boom. As shown by Table
3, the results are almost similar, under the fixed exchange rate rule in both windfall and
boom.

22
 The rest of the results shows that the flexible exchange rate regime helps to improve
welfare compared to an ER rule. Indeed, after a windflall and a boom, an oil shock
generates a more important welfare cost when the exchange regime is fixed19 . Table 3
reports that after a boom, for the sticky price model, the welfare cost is estimated at
0.0134% and 0.0173% of consumption in a deterministic steady-state, under an IT rule
(flexibe exchange rate regime) and a ER rule respectively. As for the sticky price-wage
model, the welfare is around 0.0202% and 0.0334% in the cases of an IT rule and an
ER rule respectively. After a windfall, the results show that, in the case of a sticky
price-wage model, welfare cost is lower when the central bank targets the CPI inflation
(IT rule). In other words, in the case of an ER rule, a rise in oil price leads to a greater
welfare cost.

6 Conclusion
In this paper, we have built a multisector DSGE model to model the Dutch disease
phenomenon. To do so, the model takes into account the tradable good sector, the oil
sector, the non-tradable good sector and the import sector. The tradable good and oil
sectors operate under perfect competition and the non-tradable goods sector operates
under monopolistic competition. We have, thus, attempted to compare the response
of the selected variables in the case of a windfall (increase in the oil price) and boom
(increase in oil resources) and how monetary policy should be conducted to insulate the
economy from the impacts of these shocks.
The main finding shows that the Dutch disease under both spending and resource
movement effects seems to be realized in the following cases: flexible prices and wages
both in the case of a windfall and in the case of a boom; flexible wages and sticky prices
only in the case of fixed exchange rate. In others cases, simulations have shown that
the Dutch disease could be avoided if: prices are sticky and wages are flexibles when the
exchange rate is flexible; prices and wages are sticky whatever the objective of the central
bank, in both cases: windfall and boom. Also, we compared the source of fluctuation
that leads to a Dutch disease and we concluded that the windfall leads to a strong effect
of Dutch disease in term of de-industrialization compared to a boom. The choice of
flexible exchange rate regime also helps to improve welfare compared to an ER rule.
Finally, it appears that the flexible exchange rate seems to be the best way to avoid
the Dutch disease both in the cases of a windfall and a boom. In other words, it is
preferable for a central bank, in an oil exporting economy, to adopt inflation targeting
regime to prevent the impact of oil shocks.

19
Exept in the case of a sticky-price model after a winfall where the results are almost similar.

23
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