Deindustrialization and Dynamic Adjustment

In the provided static model, a real appreciation was one of the channels of deindustrialization.

However, these two phenomena are not necessarily associated. Here, a different model is presented in which deindustrialization is inevitable, but there may be a real depreciation in the long run. This model also introduces an explicit temporal sequence of effects in the

static model. Thus, this model is able to consider dynamic issues such as the influence of expectations on the time path taken by the economy. This model, which is based on Neary and Purvis (1981), has the same sectoral structure as that of the static model but the specification of factor markets is different. In particular, it is assumed that the booming sector does not use the mobile factors in the short run, thus excluding any resource movement effect over that time horizon. However, both the booming and manufacturing sectors use stocks of capital, which can be gradually augmented or depleted with the passage of time. Manufacturing can also draw on a pool of labour, which is instantaneously mobile between that sector and the non-traded goods sector. Finally, it is assumed that both booming sector and the non-traded goods sector use a permanently specific factor.

Assuming that the economy is initially in long run equilibrium, the effects of the boom in this model are illustrated in Figure 1.5. The horizontal axis shows the stock of capital located in manufacturing sector. Thus, in the short run, the economy is constrained by the initial allocation of capital to that sector, K_M⁰ . The vertical axis shows the real exchange rate π, which is the inverse of q, the relative price of the non-traded goods. The curve SS indicates the combinations of π and KM which create equilibrium in the market for non-traded good before the boom.¹ Considering that in the short run the boom has only a spending effect in this model, the market equilibrium locus will shift from SS to S⁰S⁰ as a result of the boom.

Following the increased demand for the non-traded good, either a fall in π or contraction of the manufacturing sector (so releasing labour to non-traded sector) is required to maintain the equilibrium. With K_M fixed in the short run, the new short run equilibrium would be at point B implying a real appreciation which induces a rise in wage relative to the price of manufacturers so that manufacturing output and employment contract.

However, this real appreciation disturbs the initial capital-market equilibrium, by reduc-ing the return to capital in the manufacturreduc-ing sector. Since the return to capital in the booming sector has risen in any case as a direct consequence of the boom, there is now a clear incentive to decrease the stock of the capital in manufacturing. Whether this is done by reallocating existing capital goods or by allowing them to depreciate without replacing them, the results for the medium-run adjustments of the economy are the same: the real exchange rate gradually rises as the equilibrium point moves in a north-westerly direction along S⁰S⁰, as indicated by the arrows in the diagram. Consequently, the demand for the non-traded

1This curve is downward-sloping, since a rise in K_M leads to movement of labour from non-traded goods sector and so creates excess demand. Therefore, π must decrease which both stimulates the supply of and discourage the demand for the non-traded good.

Figure 1.5: Deindustrialization and Dynamic Adjustment

good rises, both because its relative price falls and because capital is being allocated more efficiently between sectors, which raises real income. Hence, the equilibrium output of the non-traded good must rise, which leads to labour movement from the manufacturing sector.

Since manufacturing is simultaneously losing capital, the sector’s output must fall steadily as the economy moves away from point B.

If capital is available from abroad at a fixed world rental, the long run equilibrium real exchange rate is unaffected by the boom and so the economy converges to point C. Alterna-tively, if capital is a non-traded factor available in fixed supply, the final equilibrium may be at points such as C⁰ or C⁰⁰.¹ Under each of these assumptions about the capital market, the implications for the Dutch Disease symptoms are the same: both the initial real appreciation and the subsequent real depreciation are associated with steady declines in manufacturing output and employment.

This dynamic model also allows us to consider the role of expectations. This model clearly shows that what is important is not the date at which boom occurs, but the date at which the consequences of this are foreseen by different agents in the economy. If consumers anticipate an increase in real national income, their capitalized permanent income is increased so that their current demand for non-traded good rises. Similarly, given positive adjustment costs, factor owners will begin to reallocate capital out of manufacturing and into the expected booming sector. Therefore, both the spending and the resource movement effect of the boom may lead to contraction of the output of manufacturing before any boom takes place.

1For details, see Neary and Purvis (1981).