Macroeconomic Policy Implications of Oil in Colombia

This paper develops and applies a small econometric model to illustrate the likely short-term macroeconomic effects on the economy of Colombia resulting from the recent discovery and planned development of new oil resources. In performing the analysis, the paper considers various assumptions concerning government fiscal, monetary, and exchange-rate policies so as to assess the ability of policy to influence the effects that the oil discovery will have on the economy. Comparisons of these alternative policy simulations strongly suggest that appropriate macroeconomic policies can reduce significantly the negative consequences of the 'Dutch disease,' the symptoms of which are reflected in an over-valued exchange rate and declining non-oil export and import-competing sectors. The simulations also demonstrate, however, that some degree of relative price adjustment will be needed for the Colombian economy. In particular, attempts to limit relative price adjustment through the real exchange rate simply force the requisite relative price adjustment to occur through domestic price inflation in reducing the real purchasing power of the peso. Managing this tradeoff between domestic price inflation and real appreciation of the exchange rate should be the overriding concern of macroeconomic policy.