Resource Dependence, Commodity Shocks and the Role of the Exchange Rate: An Empirical Study of Papua New Guinea

The role of the exchange rate as a ‘shock absorber’ is often undermined in resource-dependent developing countries when a negative commodity price shock hits the economy. Rather than pursuing greater flexibility, the policymakers rely more on intervention strategies which further aggravates the balance of payment crisis by leading to a forex crisis. This paper presents an empirical study of Papua New Guinea which has been facing a severe shortage of foreign currency since 2013. It examines if a sudden depreciation shock to the exchange rate stimulates the overall trade balance while simultaneously evaluating its impact on inflation. Employing a structural vector autoregression model I find that the positive trade balance effect outweighs the negative inflationary effect. Further, I find external shocks as the major sources of real business cycles and a negative response of the non-resource economy to a positive resource shock.