sluggishly to the new equilibrium.<sup>28</sup> The real exchange rate could temporarily overshoot its long-run value, amplifying the adverse consequences for the competitiveness of the non-booming tradable sector in the short run.<sup>29</sup> This transition, no matter how brief, is painful, both economically and politically. The pain of transition is aggravated if the boom ends up short-lived, which means that the costly initial adjustment must be reversed.

# **Myth 10.  Resource rich developing countries should all be concerned about Dutch disease.**

While the stylized models provide intuitively plausible characterization of an economy’s response to an export boom, it is important to emphasize that what the model predicts as the outcome of an export boom hinges critically on the several assumptions that obfuscate the reality. Although these assumptions do not invalidate the core Dutch disease model, they do point to the fact that the models’ conclusions may not be applicable in certain circumstances.

Empirical applicability of Dutch disease is generally quite limited for developing countries. Box 2 below highlights some of the most notable features of developing countries that are _not_ in line with the assumptions of the analytical model, and cautions against making a hasty diagnosis of, or prognosis for, Dutch disease, without giving adequate attention to country specific circumstances.

## **Box 2.  Dutch Disease: Assumptions and Realities in Developing Countries**

_Full employment assumption._ One of the central issues of the Dutch disease concept is the assumption that a country is operating on its production possibility frontier, that is, full employment of all factors of production. This is an unlikely condition for many developing countries, where inefficient use of existing production factors is endemic. In countries with underemployed labor, the booming tradable sector can increase production by absorbing surplus workers without bidding labor away from the other sectors. Similarly, the non-tradable sector may be able to tap on the pool of idle labor without raising wages, and expand output to eliminate excess demand.<sup>a</sup> Real appreciation of the home currency is likely to be limited, and Dutch disease may not be realized. In countries where unemployment is related to skills mismatch in the local labor market, firms may choose to scale up production by sourcing foreign skilled labor. In the absence of factor constraints, there would be little impact on the real exchange rate and the structure of the economy.

_Fully flexible and competitive market assumption._ Markets in developing countries may respond sluggishly to an export boom, or may move into a direction not predicted by the theory, influenced by market distortions, limited absorptive capacity, and other impediments that are often discussed in the context of resource curse. When market imperfections exist, the Dutch disease theory may be of little use in predicting the effect of an export boom on the economic structure.

In the presence of market distortions—e.g., administrative price controls, subsidies on key inputs or import restrictions—prices are unlikely to adjust rapidly to reflect domestic market conditions. Labor may not be easily reallocated between sectors, hampered by rigid labor regulations, skills mismatch, and other social or structural reasons. Supply response to increased demand may be quite sluggish in the absence of an enabling institutional and regulatory environment, as well as well-functioning financial intermediation. Goods and services that are otherwise tradable may not be exported or imported internationally, inhibited by trade barriers, exchange controls, as well as poor trade logistics and facilitation. Under such circumstances, how an economy responds to an export boom is unpredictable.

_Perfect substitutability assumption._ Goods and services produced in developing countries are typically imperfect substitutes for those traded on world markets. The prices of local products are thus influenced more by the

> 28 See Dornbusch (1976) for the exchange rate overshooting model.

> 29 See Buiter and Purvis (1983) who analyze the short-term dynamics of the real exchange rate, stemming from sluggish adjustment of domestic prices.

10