Monetary Policy in Resource-Rich Developing Economies

The economic literature acknowledges that to avoid the resource curse, resource- rich countries should restrict fiscal expansion and save a significant part of resource revenues outside the domestic economy. However, in these countries governments tend to ineffectively spend a considerable part of windfall revenues in the short run. In this research I construct a DSGE model for a small, open economy to show that if fiscal indiscipline in the form of immediate responses to foreign resource revenue changes is inevitable, then monetary policy can help improve the allocation problem. The simulation results indicate that targeting the exchange rate or price level through foreign exchange interventions by the central bank can soften the negative effects of Dutch Disease and stabilize the economy in the face of volatile natural resource revenues in the short run. I also find that a fixed exchange rate regime outperforms price level targeting by delivering higher isolation and hence less vulnerability to shocks in natural resource revenues. In contrast, if the central bank chooses to pursue a laissez faire policy, i.e., not to intervene, then the economy becomes vulnerable to shocks in foreign resource revenues and the resource curse becomes more severe.