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What Is Dutch Disease?


Question: What Is Dutch Disease?
Answer: Dutch disease is an affliction that often affects relatively small resource-rich countries. Consider the fictional land of Elbonia and their chief export of copper. Dutch Disease would impact Elbonia through the following steps:
  1. A massive rise in revenues from foreign exports of copper. This would be due to either a spike in world copper prices or a spike in the amount of copper exported caused by a discovery of copper deposits (or both).

  2. The increased Elbonian sales of copper on foreign markets causes an increase in demand for the Elbonian currency. Either foreigners are buying Elbonian copper with Elbonian currency, or using their own currency, which Elbonians then exchange on foreign exchange markets for their own currency. An increase in the demand for Elbonian currency causes an appreciation of Elbonian currency on foreign exchange markets (that is, it goes up in value relative to other currencies such as the U.S. dollar - for more detail see Exchange Rates: What to Use as the Base).

  3. With an appreciation of the Elbonian currency, exports of Elbonian goods becomes relatively more expensive to foreign buyers when priced in their home currency. That is, if the Elbonian currency doubles in value relative to the U.S. dollar, then ceteris paribus Elbonian goods cost twice as much to U.S. buyers as they did before. Naturally this causes the quantity demanded of non-copper Elbonian exports to fall sharply, negatively affecting the health of those industries.

Dutch Disease - The Evidence

The close relationship between the value of a country's currency and the price of their major export is well known. For instance, the value of the Canadian dollar relative to the U.S. dollar is almost perfectly correlated with changes in oil prices, as shown by the MERT predictor.

The evidence is mixed that increases in commodity revenues routinely cause large enough changes in exchange rates to have significantly negative effects on export industries and economic growth. The reason for the mixed evidence is due to the overall difficulty in 'holding all else equal' in macroeconomics - just because an economic growth in a country slowed after a currency appreciation does not mean that the currency appreciation caused the slowdown (that is, correlation does not necessarily imply causality).

And Why Exactly Is it Called Dutch Disease?

The phrase Dutch Disease was coined by The Economist in response to reduced exports and economy growth in the Netherlands following a discovery of North Sea natural gas deposits in the 1960s.

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