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Dutch Disease

An economic phenomenon wherein both the rapid development of one sector of the economy and the decline of other sectors lead to the substantial appreciation of the domestic currency

What is Dutch Disease?

Dutch disease is a concept that describes an economic phenomenon when the rapid development of one sector of the economy (particularly natural resources) and the decline of other sectors lead to the substantial appreciation of the domestic currency. Dutch disease is an economic paradox when good news for the economy, such as the discovery of natural resources, results in a negative impact on the country’s economy.

 

Dutch Disease

 

Breaking Down the Dutch Disease Phenomenon

The Dutch disease term was first introduced in The Economist magazine in 1977 to analyze the economic situation in the Netherlands after the discovery of large natural gas fields in 1959. Although the Dutch economy increased its revenues from the export of natural gas, the significant appreciation of the national currency from the large capital influx into the sector resulted in a higher unemployment rate in the country, as well as a decline in the manufacturing industry.

The phenomenon of Dutch disease is commonly attributed to countries whose economies rely heavily on the export of natural resources. The paradox contradicts the concept of comparative advantage. According to the comparative advantage model, each country should specialize in the industry in which it possesses a comparative advantage over other countries.

However, it does not work well with countries that primarily export natural resources. For example, the volatility of commodity prices cannot sustain a country’s economy for long time periods. Also, the overdependence on the export of natural resources leads to the underdevelopment of other sectors of the economy such as manufacturing and agriculture.

 

Disadvantages of Dutch Disease

The negative influence of Dutch disease on the economy can be explained by some features attributable to the sectors that are related to natural resources. For example, the industries generally require heavy capital investments, but they are not labor-demanding. Therefore, multinational corporations and foreign countries will be interested to heavily invest in the economy to explore and extract the newly discovered resources.

The foreign investments will lead to higher demand for the country’s domestic currency, and it will start appreciating. The appreciation of the domestic currency will make the country’s exports in other industries more expensive while imports will become cheaper. Subsequently, domestic producers will face lower demand for their products abroad, as well as greater competition from foreign producers. Thus, the lagging sectors of the economy will face further troubles.

 

How to Avoid Dutch Disease?

The two primary strategies that can help solve Dutch disease are listed below:

 

1, Deceleration of domestic currency appreciation

The deceleration of currency appreciation is an easier and more viable strategy to prevent the adverse effects of Dutch disease. For example, it can be achieved by smoothing the spending of revenues earned from the export of natural resources.

One of the most common methods to do so is the creation of a sovereign wealth fund. Many developed and developing countries, including Australia, Canada, Norway, and Russia, manage sovereign wealth funds nowadays.

Sovereign wealth funds aim to stabilize the inflows of the capital in the economy to prevent it from the overheating and subsequent significant currency appreciation. Due to such a reason, the funds usually invest abroad (keep money in non-domestic currency). In addition, the excess revenues can be spent on education or infrastructure that will help to diversify the economy.

 

2. Diversification of the economy

The diversification of the economy is a strategy that can almost eliminate the negative impact of Dutch disease on the economy. However, such a strategy requires a fundamental approach that may not be suitable for every country. The economy’s diversification can be achieved by subsidizing the lagging sectors of the economy or establishing tariffs to support the domestic producers.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

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  • Fixed vs. Pegged Exchange Rates
  • Negative Externalities
  • Public Goods

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