Oil production and macroeconomic adjustment in the Indonesian economy

GI~JIYJ~~Econon~ics 1994 16 (4) 253-210

Oil production and macroeconomic adjustment in the Indonesian economy Charles Harvie and Atifah Thaha

This paper is concerned with identtjying and modelling the macroeconomic contribution of’ the oil sector to the Indonesian economy. A brief overview of macroeconomic developments ,for Indonesia is conducted for the period 1970-91, j&using upon the contribution of oil revenues to GDP, the current account and government revenue. In addition a simple theoretical macroeconomic model, incorporating oil, is presented and used-for numerical simulation purposes, to identtjy and analyse potential macroeconomic developments for Indonesia arising from oil related shocks. The overview suggests that oil price shocks are of particular interest in the context of’ Indonesia, as are, therefore, the simulation results derived ,from this case. Consideration is also given to the eflects upon macroeconomic outcomes, arising .from various policy responses to oil related shocks. In particular emphasis is given to the use of oil revenues for the purpose ofstimulating domestic demand or the supply side of the economy, and the adoption of a more, or less, export orientated policy towards oil production. K~Jw.w~s: Oil production;

Macroeconomic

model: Indonesia

affect the private sector, through its impact upon domestic real income, private sector wealth and the current account (see for example Buiter and Purvis [4] and Eastwood and Venables [7], in which emphasis is placed upon the short to medium term, and Harvie [S] and Harvie and Gower [9] for that emphasizing the long-term nature of the adjustment process). In the case of Indonesia this is clearly inappropriate; hence theoretical macroeconomic modelling for this country must explicitly allow for such a difference. Indonesia produces sizeable quantities of both non-oil traded and non-traded goods, which have traditionally had a strong agricultural base. Oil booms could have a potentially adverse impact upon non-oil trade, arising from the so called Dutch disease effect, and in Indonesia there is strong evidence to suggest that this has happened for the agricultural sector, which has experienced a decline in its relative contribution to both output and exports. A significant structural change in domestic output from agriculture to manufacturing is apparent, which, to a large extent, has been initiated by deliberate policy action. Focus is placed upon explaining such developments in Indonesia by developing an appropriate dynamic

The Indonesian economy presents a particularly interesting case for analysing the macroeconomic effects arising from oil related shocks, due to the fact that the oil revenues generated accrue primarily to government. Such revenues therefore have no direct effect upon the private sector. The way in which the government spends such revenue domestically, on consumption and/or investment, is clearly politically determined, and will have a major bearing upon the evolution of the macroeconomy. It is the objective of this paper to identify the macroeconomic consequences for Indonesia arising from oil related shocks, and how such outcomes can be influenced by alternative government initiated policy responses. The paper focuses on two responses: a capital transfer to the private sector, to affect the supply side of the economy, and a change in oil exports. The existing theoretical literature, on the macroeconomic consequences arising from oil production, focuses upon the case where oil revenues primarily The authors are with the University of Wollongong, Department of Economics, Northfields Avenue, PO Box 1144, Wollongong 2522, NSW, Australia.

0140-9883/94/040253--18

(C> 1994 Butterworth-Heinemann

Ltd

253

Oil production

and macroeconomic

u@stment

in Indonesia:

C Hake

und A Thuhu

n Series A 80

60 r" 40

1980

1970 Source:

United

1990

Nations

Figure 1. Indonesian

oil production

1970-91.

100 X

G

80

C -

60 40 20 0 1970

Source:

1980

OECD

Figure 2. Real oil price 197&91 (1985 = 100).

theoretical macroeconomic model emphasizing the short- and medium-term adjustment process, as well as the longer term evolution of the economy, arising from oil related developments. The effect upon such outcomes from different policy responses, arising specifically for the cases of a capital transfer to the private sector and increased/decreased exports of oil, is also emphasized. The paper proceeds as follows. In the next section a brief historical review is conducted of the development of the oil sector in Indonesia, and its contribution to the macroeconomy. Particular emphasis is placed upon its contribution to government income, domestic real income (GDP) and the current account. The following section incorporates the key characteristics of Indonesian oil production, in the context of a theoretical macroeconomic framework. In addition this section identifies briefly the steady state and dynamic properties of the model. The results derived

254

from simulating the model for oil related disturbances and that of an associated capital transfer to the private sector and expansion/contraction of oil exports are then presented. The last section is a summary of the major conclusions derivable from this paper.

Oil developments and the Indonesian economy: a brief historical review Oil e.uplorution und production The production of sizeable quantities of oil began in the late 1950s and the early 1960s increasing significantly again by the early 1970s. It increased further by the mid-1970s and, as Figure 1 indicates, has remained between 65S80 Mt annually since, with the exception of the years 1977 and more recently 1990. A major influence upon such production has

Oil production

and mucroeconomic

adjustment

in Indonesia:

C Harvie and A Thaha

demand effect, while the resource movement been small.

been the production quotas set for Indonesia, arising from its membership of OPEC. Another primary influence upon the oil revenues generated has been the world price (real) of oil. As Figure 2 indicates, this has fluctuated quite considerably during the 1970s and 1980s. From the heady days of the late 1970s and early 1980s the real oil price has experienced a sharp downward trend recovering slightly by 1990. While Indonesia’s production of oil is surpassed by a number of other oil producing economies (see Table l), it is still a major marginal producer in world terms, being able to exert an important influence over the world price of oil. It has also contributed over the period 1957791 between 4 and 10% of total OPEC oil production. Its contribution to the evolution of the macroeconomy has been an important one, and is likely to remain so into the future. Oil production in Indonesia is best characterized as being highly capital intensive, predominantly financed by overseas firms with minimal effect upon domestic financial markets. Correspondingly the requirements for domestic labour has been relatively small. In 1988, for example, only 13 000 workers were employed in the mining sector (this includes oil), of which 5% were foreign workers. This represented barely 0.02% of the 72 million Indonesian total labour force. The windfall gains, or economic rents, arising from oil production have generated, using the terminology of Corden and Neary [S], a strong spending or

effect has

Oil and the macroeconomy A number of key macroeconomic variables have been affected by the oil developments just identified, three of which will be given emphasis. These are government revenue, the current account and real GDP. Government revenue In Indonesia most of the oil output is produced by foreign companies; however, there is an output sharing arrangement whereby 86% of this goes to the government and 14% to the foreign oil companies. Such an arrangement has had a profound impact upon government revenues, as indicated by Table 2. In real terms oil and gas revenue contributed 33% of total government revenue in 1973-74, over 50% by 1979-80 and at its peak in 1981-82 62%. Since then it has declined, a reflection of the weakening of the price of oil on world markets, as well as a slight reduction in oil production. However, despite this decline, the contribution of oil revenue to total revenue has not fallen to below 25% during the 1980s and early 1990s (Table 2). To maintain its balanced budget policy, the government spends all of this income in the form of consumption or investment expenditure. The former is referred to as routine expenditure whilst the latter is referred to as development expenditure, and is

Table 1. Average oil production selected countries 1957-91 (Mt).

1957 1963 I970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Sourw:

Indonesia

OPEC

Saudi Arabia

USA

USSR

Mexico

UK

Ind/ OPEC

15.47 21.12 36.62 43.79 54.08 66.10 67.98 64.14 74.20 93.95 80.48 78.07 77.63 78.66 65.86 65.92 68.52 67.76 71.02 64.58 65.34 69.32 83.52 72.38

334.71 539.99 I 134.94 1230.35 1332.10 1223.87 1505.81 1353.30 1523.02 1689.19 1602.73 1524.18 1332.36 1126.21 931.28 823.51 795.73 756.76 879.30 865.86 1000.18 1084.81 1173.16 1161.98

49.01 80.98 176.86 223.51 285.58 364.34 407.92 352.39 425.X 1 457.08 410.33 475.97 495.72 490.80 324.88 250.90 204.18 158.50 251.68 211.13 255.16 252.43 320.38 408.80

353.64 373.13 475.28 466.70 466.96 454.19 432.36 413.09 401.26 405.7 1 428.80 420.82 424.20 421.80 425.59 427.5 1 432.12 441.36 428.16 409.9 I 410.64 382.68 37 I .03 373.32

98.35 206.00 353.04 377.08 401.08 429.04 459.00 491.00 520.00 545.80 572.46 585.56 603.20 608.82 612.60 618.00 612.23 595.00 614.75

12.62 16.43 21.50 21.41 22.16 23.26 29.70 36.46 41.34 49.28 60.83 75.46 99.94 120.20 142.79 138.58 139.94 135.67 126.23 132.08 130.68 130.67 132.47 139.12

0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.61 12.17 37.54 53.38 76.60 78.91 87.95 100.31 110.83 121.19 122.50 121.16 117.54 110.77 87.41 88.00 87.23

4.62 3.91 3.23 3.56 4.06 5.40 4.51 4.74 4.87 5.56 5.02 5.12 5.83 6.98 7.07 8.00 3.51 3.95 3.54 7.46 6.53 6.39 7.12 6.23

UN Mmthly

Bulletin

of Stnrisrics.

na “a na na na

Table 2. Real government revenue (1980 prices, billion rupiab).

Development”

Routineh

Of which oil and gas’

Total

(2)

(3)

(4)

(5)

(6) = (4)/(5)

(7) = (w(5)

I 186.35

32.62 4x.20 45.66 44.32 45.23 43.55 52.73 59.89

17.4 11.7 18.0 21.2 17.9 19.5 17.1 12.7

61.97 56.90 5 1.98 53.7x 4x.x3 28.95 37.27 28.87 29.48 25.15 2X.93

12.3 13.5 21.2 17.9 15.7 26.3 22.X 30.3 24.7 26.3 20.0

1973-74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 19X0-8 I 198lL82

632.91 535.99 949.34 I 29X. 18 I 160.72 1 459.26 1 520.53 1406.36 I 48X.68

1982-X3 19X3-84 1984485 19X5-86 19X6-87 1987-88 1988-89 1989-90 1990-91 1991-92

1 540.9 1 2 753.4x 2 265.80 2221.70 3 377.94 3312.80 4971.88 4406.14 4 909.84 4 144.29

3 003.75 4 05 1.56 4 329.3X 4813.10 5 305.93 601 1.91 7 372.90 9 627.70

2221.41 2410.04 2 708.49 2 924.61 3 253.48 4 6X9.64 6 608.25

3 636.66 4 587.54 5 278.72 6111.2X 6 466.66 7471.16 8 893.44 I 1 034.05

10638.15 9 X63.3X 10 235.96 IO 36X.40 I I 973.20 9 478.64 11 191.34 I 1 446.82 13 430.09 13 736.59 16556.85

7515.33 64X9.59 6751.91 6 794.72 6 930.72 3 721.95 5 405.07 4 740.65 5 258.02 4 689.77 5 987.70

12 126.83 II 404.29 12 989.43 12 634.20 14 194.90 12 856.40 14504.14 16418.70 17 X36.23 18 646.43 20 700.34

Sorww: Budget statement. various years. “Foreign gas. ‘Domestic revenue from oil and gas.

Table 3. Real government expenditure

1973 74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 19x0- 81 19x1 x2 10x2- x3 1983-X4 19x4-x5 19X6-87 1987-88 19xX-89 19x9-90 1990 91 1991-92

borrowing

and loans to support

Routineb

Of which debt paymentC

Total

(2)

(3)

(4)

(5)

1422.57 2 240.06 2 705.3 1 3411.90 3241.58 3 604.66 4421.56 5 573.84 6 048.78 5 847.50 7 023.62 6 485.02 4 893.50 5 099.83 6 09X.60 6 466.45 X 460.1 1 X 665.22

2214.09 2451.45 2 573.41 2 699.3X 3 225.07 3 X66.50 447l.XX 5 460.12 6078.05 5 557.03 5 965.82 6 142.67 7 962.61 9 404.48 10319.75 1 1 369.X3 13 046.80 12035.12

219.45 170.27 15 1.59 313.X6 342.63 753.23 753.17 73x.x 1 795.38 972.60 1491.21 1 X08.79 2 970.33 4413.x1 5 443.X6 5 578.91 5 X25.78 5 348.68

various

sector. hDomestic

revenue

including

oil and

(1980 prices, billion rupiah).

Development”

S’otrw,; Budget statement, ‘Foreign debt payments.

the private

years. “Mostly

spent on invcstmcnt

3 636.66 4691.51 5 278.72 6 I Il.28 6 466.66 7 474.16 8 x93.44

1 1033.96 12 126.X3 II 404.53 12 989.43 12 627.69 12X56.10 14504.31 16418.36 17 X36.28 21 506.91 20 700.34 to support

the private

(6) = (3105)

(7) = (w(5)

(8) = (4)/(5)

60.88 52.25 48.75 44. I7 49.87 51.75 50.2x 49.4x 50.12 48.73 45.93 48.64 61.94 64.84 62.X5 63.75 60.66 5x.14

39.12 47.75 51.25 55.83 50.13 4x.25 49.72 50.52 49.8X 51.27 54.07 51.36 3X.06 35.16 37.15 36.25 39.34 41.X6

6.03 3.63 2.87 5.14 5.30 10.08 8.47 6.70 6.56 x.53 1 1.48 14.32 23.10 30.43 33.16 31.2x 27.09 25.84

sector.

“Mostly

for consumption

expenditure.

equivalent to that of a capital transfer’ to the private sector. During the period of rapid increase in oil production and prices, the share of development

to total expenditure increased from 39% in 1973-74 to around 54% in 1983-84 (see Table 3). However, with the collapse in oil prices this share has fallen to around 3540% of total government expenditure.

‘Such a capital transfer in the context of this paper could take a variety of forms, including that of a price subsidy on inputs and capital, capital stock, technology improvement, education and training. research and development and infrastructure improvements.

Current mrount A second major impact of oil production and price developments has been upon the current account. Indonesia’s oil exports have been a major source of

Oil production Table 4. Current

account

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 I984 1985 1986 1987 1988 1989 1990 1991

Table 5. Exports

(1980 prices, million

Contribution 1973-82 1983-89

udjustment

in Indonesicr: C Hctrcie and A Thuha

US$).

Oil trade (2)

Non-oil trade (3)

Services trade (4)

Trade balance (5)=(z)+(3)

Current account (6) = (4) + (5)

4 857.46 I I 679.44 9 766.26 9 219.42 9 973.88 10435.89 10316.21 15 093.56 16 499.56 11 798.49 8 507.66 8 678.37 7 117.85 4 222.40 4 028.36 3 370.00 3 497.06 4225.10 3 417.99

- 3 362.26 - 3 398.44 -5261.53 - 4 460.32 - 3 036.72 - 3 456.27 - 1081.58 -2 746.16 -6 140.33 - 7 454.25 - 5 107.59 - 3 462.93 - 1 939.49 ~ I 822.57 - 1464.78 ~ 399.33 - 787.07 ~ I 747.17 -2 114.79

- 3 408.20 -4 844.68 ~15501.10 -4 549.76 - 5 042.69 -8212.98 -5451.95 ~ 6 024.02 ~ 6 639.37 -2661.64 -5251.77 -5001.30 -4 833.33 - 3 850.55 -3 735.11 - 3 592.68 - 3 764.07 -3851.67 ~ 3 688.02

I 495.20 8281.00 4 504.72 4759.1 I 6937.16 6 979.62 9 234.62 12 347.40 10 359.23 4 344.24 3 400.07 5215.44 5 178.36 2 399.83 2 563.58 2 970.68 2 709.99 2 477.93 I 303.21

~ 1913.00 3 436.33 - 10996.38 209.35 I 894.46 ~ 1 233.36 3 782.67 6 323.38 3 719.86 1682.61 - 1851.70 214.14 345.02 - 1450.73 - 1 171.53 ~ 622.00 ~ I 054.08 ~ I 373.75 -2384.81

by sector (%). Petroleum

Agriculture 1970 1971 1972 I973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 19x7 19X8 I989 1990

und mucroeconomic

50.10 54.20 42.00 43.60 24.90 20.50 24.90 26.60 26.00 27.90 21.80 11.80 10.60 12.50 14.00 15.90 21.30 21.20 23.50 22.45 20.17 to total export ~ 1.32 0.58

Oil and gas”

38.50 39.10 51.40 50.10 70.20 74.80 70.30 67.20 63.90 56.90 58.70 72.20 69.40 64.10 57.00 48.90 37.20 35.90 27.70 26.98 33.66 growth

Sourw: Calculated from Annual ‘Including petroleum.

38.50 39.10 51.40 50.10 70.20 74.80 70.30 67.90 68.60 65.20 7 I .90 82.10 82.40 76.40 73.30 68.60 56.10 50.10 41.90 39.17 4X.86

Manufacturing

Other

Non-oil

Oil

I .20 1.60 I .90 2.80 2.20 1.20 1.40 1.80 1.90 3.10 2.40 2.90 4.30 7.60 9.20 II.20 18.00 24.30 28.70 27.87 26.93

10.20 5.10 4.70 3.50 2.70 3.50 3.40 3.70 3.50 3.80 3.90 3.20 2.70 3.50 3.50 4.30 4.60 4.40 5.90 IO.51 4.03

61.50 60.90 48.60 49.90 29.80 25.20 29.70 32.10 31.40 34.80 28.10 17.90 17.60 23.60 26.70 31.40 43.90 49.90 5X.10 60.83 51.14

38.50 39.10 51.40 50.10 70.20 74.80 70.30 67.90 68.60 65.20 71.90 82.10 82.40 76.40 73.30 68.60 56. IO 50. IO 41.90 39.17 48.86

0.48 2.7 1

0.15 I .29

Total 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 IO0 100 100 100 100 100

by sector (%) 5.62 - 6.92

Report,

Central

4.9 ~ 2.34

Bank of Indonesia

total export revenue, and a major source of foreign exchange. This has been very important in stimulating the economic growth of the country, through the financing of imported inputs, technology and services vital to economic development Table 4 identifies developments in the current account over the period 1973-91, broken down into

oil trade, non oil trade, the trade balance, services balance and the current account itself. The 1970s and 1980s saw sizeable surpluses in oil trade, peaking in 1981 at US$16.5 billion (US$). Since then, with declining oil production and prices, there has been a steady decline in the oil trade surplus. However despite this it has continually exceeded the non-oil

Oil production

and nlacroc’conomic

adjustment

in Indonesiu:

trade deficit, contributing to balance of trade surpluses. The services trade balance has been in persistent deficit throughout this period, and of sufficient magnitude to have created overall current account deficits on a number of occasions. In fact the current account has been in continual deficit since 1986, reflecting a decline in the oil trade surplus and a persistent services deficit of between USS3.54 billion annually. Table 5 identifies export performance by sector over the period 197&90. In 1970 agriculture contributed 50.1% of Indonesia’s exports, oil and gas 38.5%, manufacturing only 1.2% and other sectors 10.2%. By 1975 the contribution of oil and gas virtually doubled to 74.8% of total exports, agriculture contributed only 20.5%, manufacturing still only 1.2% and other sectors 3.5%. A substantial reversal of roles for agriculture and oil and gas is therefore apparent over this short period of time. By 1981 the contribution of oil and gas further increased to 82.1% (with the contribution of petroleum alone being 72.2%) agriculture only 11.8%, manufacturing 2.9% and other sectors 3.2%. During the remainder of the 1980s the post-boom era, the contribution of oil experienced a declining share, although this trend was reversed in 1990. As the significance of oil to total exports waned in the 1980s this was offset by the increased importance of manufactured exports in particular. Agricultural export share also improved with the exception of 1990. Deliberate policy action by government to develop the manufacturing sector, as a result of falling oil revenue from weakening oil prices during the 1980s has therefore proved to be successful both in terms of manufactured goods production as well as its export performance Table 5 also summarizes the contribution by sector to total export growth. Over the oil boom period, 1973-82, positive total export growth was experienced, with the major contribution to this coming from the oil and gas sector and with positive contributions also from the manufacturing and other sectors. However, the agricultural sector experienced a decline in export growth. During the post-oil boom period, 1983-89, the overall growth of total exports was negative, and this was largely a reflection of a deterioration in export growth of the oil and gas sector. This was offset, however, by positive contributions to export growth from agriculture, the increasingly important manufacturing sector and other sectors. GDP Table 6 summarizes developments in Indonesia’s real GDP over the period 1973-91, both in total and by major sector. It also identifies the growth of GDP and the contribution to this broken down by sector, during

258

C Hurcie utxi A Thahu both the oil boom and post oil boom periods. Developments in Indonesia’s GDP by sector indicates some of the major structural changes which have taken place over this period of time. In 1973 the mining sector (oil and gas production were not identified separately until 1983) contributed 12.3% of real GDP, manufacturing 9.6%, agriculture 40.1% and others 38%. Non-oil output therefore contributed 87.7% of GDP. By 1981 mining’s contribution to GDP virtually doubled to 24%, manufacturing increased to 10.8%, agriculture declined to only 25.3% and other sectors increased slightly to 40%. During the 1980s with weakening oil prices, oil’s contribution to GDP steadily declined such that by 1991 it contributed 11.3% of GDP (the mining sector in total 13.6%), manufacturing 21.3%, agriculture 19.5% and other sectors 45.7%. Table 6 also identifies the contribution to growth of GDP by sector during the oil boom and post-oil boom period. During the period 197482 the mineral sector contributed 30.6% of the growth in GDP, agriculture 12.8%, manufacturing 13.7% and other sectors 42.9%. During the post-oil boom period 1983391 the contribution of the mining sector fell to 6.6%, agriculture remained static at 12.2%, manufacturing’s contribution increased substantially to 29.2% and the other sectors increased to 51.9%. Indonesia’s economy has therefore seen major structural changes over the period 1973391. By 1991 the contribution of oil, in comparison to 1973, to GDP remained unchanged, while the contribution of agriculture halved and that of manufacturing doubled. While there has been an absolute increase in the production by all sectors of the economy, the major change has been a decline in the relative significance of agriculture. This sector contributed half of total exports in 1973 but barely a quarter by the late 1980s. The manufacturing sector, however, has grown in relative significance. The demise in the traditional exporting sector, agriculture, arising from these structural developments is not surprising. The Dutch disease effect suggests that the production of oil, and changes in its price, as well as its export, are likely to have adverse effects on the traditional export sector. This could occur through price and/or exchange rate effects. Indonesia operated a fixed exchange rate policy until 1983; hence the relevant mechanism at work here would be a change in relative prices of traded to non-traded goods, resulting in a loss of competitiveness for domestic agricultural producers. Over the remainder of the period 1983391, and the movement towards a more flexible exchange rate, developments in the exchange rate itself would have contributed towards these structural adjustments. Developments in the price of

Eneryy Economics

I994 Volume 16 Number 4

2

F 4

2 2 f

m

3

s P

a”

of GDP

na na na na na na na na na 10711.34 10369.18 7 825.75 6 167.11 8 596.40 7 734.07 9 090.22 9 354.53 10211.69

Oil and gas’ na (4) 2056.16 2 170.00 2 407.05 2 726.8 I 3 078.74 3 644.83 4 978.03 5071.17 6 100.64 7018.72 8 542.61 9 641.42 9915.43 11 378.23 13 063.03 14 286.79 17409.81 19 244.69

Manufacturing 2017.61 (5)

by sector, as per cent of total GDP growth 30.60 13.70 6.60 29.20

5 484.63 4 798.45 4 852.85 5 402.44 6 140.85 7 684.47 10 988.49 11 298.43 9 299.29 11423.69 11034.20 8 439.55 6 754.94 9 288.98 8 539.73 10 154.16 11068.08 12 303.23

Mining 2 579.43 (3)

by industry of origin (1980 prices, billion rupiah).

Sourer: Sfaii.stical Amrual Book, Bureau of Statistics, Indonesia. “Up until 1982 oil and gas data were not provided separately but were included

to growth 12.80 12.20

8 079.08 7731.05 7 969.94 8 863.29 9 450.28 9 903.90 10 628.69 11 883.71 12445.04 12 124.96 13 302.74 14000.44 14605.27 15 663.46 17014.68 17 414.59 18331.41 17 605.33

1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

Contribution 1974-82 1983-91

Agriculture 8411.87 (2)

1973

Table 6. Real domestic product

in mining.

42.90 51.90

9 118.72 9 714.69 10 387.09 11538.77 13 384.42 14025.45 16 187.37 18 808.54 19 520.10 24 522.20 25 677.52 28 239.99 29 024.03 30 816.77 32 052.04 35 869.61 38 835.26 41 290.44

Others 7 953.71 (6)

100 100

24 738.59 24414.19 25 616.93 28 531.29 32 054.29 35 258.65 42 782.57 47 061.85 47 365.05 55 089.57 58 557.07 60 321.39 60 299.66 67 147.45 70 669.49 77 725.16 85 644.56 90 443.69

Total 20 962.62 (7) 32.66 31.67 31.11 31.07 29.48 28.09 24.84 25.25 26.27 22.01 22.72 23.21 24.22 23.33 24.08 22.41 21.40 19.47

(S)=(2)/(7) 40.13 22.17 19.65 18.94 18.94 19.16 21.79 25.68 24.01 19.63 20.74 18.84 13.99 11.20 13.83 12.08 13.06 12.92 13.60

(9)=(3)/(7) 12.30 na na na na na na na na na 19.44 17.71 12.97 10.23 12.80 10.94 11.70 10.92 11.29

(l@=(4)/(7) na

8.31 8.89 9.40 9.56 9.60 10.34 11.64 10.78 12.88 12.74 14.59 15.98 16.44 16.95 18.48 18.38 20.33 21.28

(I9.62 1)=(5)/(7)

36.86 39.79 40.55 40.44 41.76 39.78 37.84 39.97 41.21 44.51 43.85 46.82 48.13 45.89 45.35 46.15 45.34 45.65

~;;4=(6)/(7)

Oil production

und macroec’ononGc’ ucjjustment

in Indonesia:

oil appear to go hand in hand with inverse developments in the contribution of the agricultural sector towards GDP and exports. In conclusion the main characteristics of oil production in Indonesia are as follows. First, its production has been substantial throughout the period of the mid-1970s to 1991, with the revenue generated also being affected by changes in the world price of oil. Focus upon developments in this sector are particularly pertinent in explaining developments in the overall macroeconomy. Second, the economic rents generated from oil production have primarily accrued to the government, enabling it to increase both its consumption and investment expenditure. Domestic resource requirements have been negligible. Hence, using the terminology of Corden and Neary [S], the spending effect (the extra income and demand generated from oil production) has been much more important than the resource movement effect (the need to transfer domestic resources away from non-oil towards oil production) in transmitting the effects of oil production to the overall macroeconomy. The spending effect itself is dominated by government policy decisions. Third, oil production and price developments exert a major influence upon developments in the current account, and the accumulation of foreign asset stocks, and thereby the exchange rate if this is flexible or the money stock if it is fixed. Such current account developments require further macroeconomic adjustment. In the following section we present a theoretical macroeconomic model for Indonesia, incorporating these fundamental features.

Theoretical framework: the model The theoretical framework adopted has its foundations in the contributions of Dornbusch [6], Buiter and Miller [3], Eastwood and Venables [7], Neary and Van Wijnbergen [ 111, Buiter and Purvis [4] and, most importantly from this paper’s perspective, Harvie and Gower [9]. In each of these a deterministic framework is adopted, in which economic agents are assumed to possess rational expectations. This is equivalent to the case of perfect foresight. Financial markets are assumed to be in continual equilibrium, while non-linancial markets, subject to sticky price and quantity adjustment arising from contracts or adjustment costs, are not. Emphasis is placed upon the long-term nature of the adjustment process, through incorporation of capital stock accumulation and foreign asset stock accumulation via the current account, indicating that the long-run steady state will have a major bearing also upon the adjustment process over the short and medium run. A number of amendments to this framework are

260

C Hurvie cd

A Thuh

required in order for it to be more applicable for the analysis of the case of Indonesia. These are as follows:

(9 Government

(ii)

(iii) (iv)

(v)

spending is endogenous, reflecting the crucial role, as identified in the previous section, which this sector plays in the transmission of oil shocks to the domestic economy. It is the major beneficiary of oil revenue, which it spends in order to maintain its balanced budget policy. The way in which it spends the oil revenue will have a major bearing upon the future evolution of the economy, an issue taken up in the following section. Government spending is in either one of two forms. First, such expenditure could be routine (consumption) expenditure, stimulating the demand for domestic non-oil output. Second, the expenditure could be in the form of development expenditure, which we refer to as a capital transfer, enhancing the supply of non-oil output. Oil exports are exogenously determined by the government. Less than perfect capital mobility is assumed. Hence domestic and foreign financial assets are not perfect substitutes. In the present context returns on domestic financial assets are equalized continuously, but this can diverge, temporarily, from that on foreign financial assets outwith equilibrium. This is in contrast to the Harvie and Gower model. The existence of a flexible exchange rate is emphasized, making the analysis more applicable to Indonesia post-1983. The importance of income, wealth and the current account for the dynamics of adjustment, as in Harvie and Gower, is still maintained.

The equations of the model, where all of the variables are in log form except that of the domestic nominal interest rate (r) and the world interest rate (3, are categorized under the following broad headings: goods market, prices, asset market, foreign trade sector and definitions. Goorls rnurket

Oil production

and macroeconomic

ig=B41(ysod+po*+e-pc)

(4)

igc = aig

(5)

igk=(l

(6)

-0)ig

ysod = yyso

(7)

&=lIq

(8)

ysno=Bsl

+t5z(pn-pc)+b’s3igk+B5,k

(9)

Prices

pc=a,pn+cc,(e+po*)+(l

-cIi -

8, = G(ydno - ysno) + ti

cc,)(e+pt*)

(10) (11)

Asset market m=L,y-&r+i.,w’+pc

(12)

w”=R,(m-pc)+o,(k+q)+R,yP+R,(f+e-pc) (13) ,f= -$(r-r*-6)

(14)

R=r?,

+r,y-r,k

(15)

~=a,-‘(q-~o,R+a,(r-fi))

(16)

Foreign

sector

.j’=~I(ot+po*+e-pc)+~2not+~L,(r*f+e-pc) -(e-pc) not=e,(e+pt*-PC)ot=(l

-y)yso

~~y+.z~y*

(17) (18) (19)

DLlfinitions c=e-pn

(20)

l=m-pn

(21)

Equilibrium in the model depends upon equilibrium in the goods market, asset market and foreign trade sector. Equilibrium in the goods market is discussed first. Total spending (demand) on non-oil output (ydno) is given by Equation (1). It depends upon real income (y), domestic gross investment (k+,/J,,k), where k is the physical capital stock and a dot (‘) above a variable

a&istment

in Indonesiu:

C Hnrvie and A Thuhu

signifies its rate of change, and /II3 is the rate of capital depreciation, fiscal policy (routine or demand generating expenditure) (igc), the non-oil trade balance (not) and domestic private sector real wealth (we). Non-oil output can be viewed as a good which can be either consumed domestically or exported, and is an imperfect substitute for the equivalent overseas non-oil imported good. Real income is given by Equation (2). It depends upon non-oil output (ysno), oil production (yso) (assumed exogenous), the world price (PO*) of oil expressed in overseas currency (exogenous), the real exchange rate, emphasized here as being (e - pn), that is the nominal exchange rate (e) deflated by domestic non-oil prices (pn), and the exogenously determined world price of the non oil imported product (PC*).

It is assumed that the parameter lj2i is the share of non-oil production in total value-added. It is further assumed that pZ1 does not change with oil production (see Buiter and Purvis [4]). If the share of oil output in domestic real income (1 -/~‘~i) is larger than its share in domestic consumption (a,), this economy will be an oil exporter, a case emphasized throughout. Equation (3) identifies the economy’s permanent income, derived in a similar fashion to that of real income, consisting of that from non-oil (ysnoP) and oil production (yso”). The actual real exchange rate, world price of non-oil output and oil price, and not their permanent equivalents, are used to calculate permanent income (see Buiter and Purvis [4]). For simplicity the parameter fi3i has the same characteristics as that for the parameter fiZ1. Equation (4) indicates that real government expenditure (is), the sum of routine (igc) and development expenditure (igk), is endogenously determined, depending positively upon the real domestic currency value of oil revenue (the domestically utilized portion of oil output (ysod) converted into real domestic currency terms). The government is assumed to spend a proportion (a) of its total (oil) revenue on routine expenditure (Equation (5)), with the remainder (1 -a) spent on developmental expenditure (Equation (6)). The government determines how much of oil output (y) is utilized in the domestic economy, as in Equation (7). Equation (8), the investment equation, captures the partial adjustment hypothesis. This partial adjustment arises from costs of adjusting the physical capital stock (k) to the desired capital stock (k*), as in Equation (22): l;=Q(k*-k)

with

the desired

(22)

capital

stock

depending

upon

its

261

Oil production

market

und macroeconomic

value as given by Equation

k*=k+q

adjustment

in Indonesia:

(23): (22)

where q is Tobin’s q, the ratio of the marginal market valuation of capital relative to the replacement cost of the capital. Substituting (23) into (22) Equation (8) can be obtained. Hence net investment adjusts positively to Tobin’s q The supply of non-oil output (ysno) is endogenously determined, fluctuating in the long run, as well as the short run, as given by Equation (9). This relates non-oil output supply to the price ratio of non-oil output to that of the consumer price level, government developmental (supply) expenditure in the form of a capital transfer to the private sector (igk) and the physical capital stock generated by the private sector itself. Price developments are given by Equations (10) and (11). Emphasis is placed upon the sticky or slow adjustment of domestic non-oil goods prices. Equation (10) identifies the consumer price level which is a weighted average of domestic (PC), non-oil prices (pn), the domestic currency cost of oil (e +po*), and the domestic currency cost of the overseas imported non-oil good (e + pt*). The adjustment of the domestic non-oil goods price is generated by an expectations augmented Phillips curve, as given by Equation (11). Such adjustment arises from two possible sources, excess demand for the domestic non-oil good relative to its available supply (ydno - ysno) and inflationary expectations. Inflationary expectations are assumed to adjust in line with developments in the monetary growth rate (ti). Asset market equilibrium is given by Equations (12H16). There are three non-money assets in the model (domestic bonds and equities, the latter representing claims to the ownership of the capital stock in the private sector, and foreign bonds). Domestic financial assets are assumed to be perfect substitutes, with arbitrage between them resulting, instantaneously, in the same expected rate of return. However, given the presumption of imperfect capital mobility, the return on domestic financial assets is not continuously equated with that on foreign assets (bonds). Only gradually will the return on these financial assets be equated. Money market equilibrium is characterized by a conventional LM equation, as in Equation (12), incorporating domestic real wealth. Demand for real money balances (the nominal money stock (m) deflated by the consumer price level (PC) depends upon real income (y) representing a transactions demand, the domestic nominal interest rate (r) and domestic real wealth (w’) representing an asset demand for money.

262

C Hurvie and A Thuhu

This market is assumed to be in continual equilibrium. Domestic private sector real wealth is given by Equation (13). This consists of real money balances (m-PC), the real value of the capital stock held by the private sector, consisting of a physical quantity (k) and its market valuation (as given by q), permanent income (yp) and the real domestic currency value of domestically held foreign assets (bonds). Domestic bonds are assumed to be inside bonds, that is they are issued by agents in the private sector and held by agents in the same sector. Hence they are not considered part of the private sector’s net wealth. These bonds, as with equities, are assumed to be held only by domestic residents. Foreign assets (bonds) are accumulated gradually with developments in the current account, as given by Equation (14). The assumption of imperfect capital mobility produces a discrepancy between the return on domestic financial assets and foreign financial assets, which can persist for a prolonged period of time. Hence a divergence between the domestic interest rate and foreign interest rate, after allowing for exchange rate expectations, is eliminated slowly, resulting in a gradual outflow or inflow of foreign assets (bonds). Real profit, return on capital services, is given by Equation (15), which is assumed to be an increasing function of real income and a decreasing function of the capital stock. Since domestic financial assets are perfect substitutes, from the perspective of domestic residents, the expected return on these are equated continuously. The expected real return on domestic bonds is equivalent to:2 r-th

where ti represents inflationary expectations, which are continuously equivalent to the real rate of return on domestic equities. The expected real return on holding equities is given by Equation (24): (24)

Ljlq + Rlq

where q is the value (real) of these equities, and R the real profit stream derived from the capital services. That is the expected return depends upon the expected capital gain/loss from holding equity capital (j/q, where d=O in steady state, plus the real profit stream derived from the capital services R relative to 4.

‘We ignore possible capital gains to domestic bond holdings.

Enrry,v

Economics

residents

1994 Volume

on domestic

16 Number

4

Oil production Continual and instantaneous arbitrage domestic bonds and equities implies:

and macroeconomic between

u&.atment

in Indonesia:

C Harvie und A Thuhu

r=rh+r* q=o

(25) R=r*=r-k and taking for q:

a log linear

q=o,R-o,(r-rh)+

approximation

we can solve

c3Lj

(26)

and solving for 4, we obtain or rearranging, Equation (16). The overseas sector consists of the current account, the non-oil trade balance and the oil trade balance. Developments in the current account are given by Equation (27): ~+e-pc=~l(ot+po*+e-pc)+y2not + k(r*f+ e - Pc)

(27)

where ot represents exports of oil. Rearranging (27) and expressing this in terms of changes in foreign asset (bond) holdings, Equation (17) is obtained. This indicates that the accumulation/decumulation of foreign assets, as reflected in the current account balance (f), depends upon the oil trade balance (ot), the non-oil trade balance (not) and real interest earnings on foreign assets (ry). In long-run steady state the current account balance must be zero, otherwise further wealth effects will arise requiring further macroeconomic adjustment. Equation (18) specifies the non-oil trade balance. This depends upon the real exchange rate (e + pt* -pn), domestic real income, and world real income (y*). Oil exports, Equation (19), are exogenously determined, dependent upon governmental policy towards the usage of such oil for domestic or export purposes. Finally Equations (20) and (21) define two variables which are used extensively throughout this paper, the real exchange rate (c) and real money balances (1) respectively.

Steady state and dynamic properties of the model The long-run steady state and dynamic of the model are now briefly identified.

properties

Steady state properties The model has the following steady state properties:

Energy

Economics

1994 Volume

analytically

16 Number

4

unambiguous

The remaining endogenous variables of the model, and their response to exogenous shocks, are all highly analytically ambiguous. This is not surprising given the size and generality of the model under analysis. This difficulty can be overcome by a numerical solution of the model. In the following section of the paper a number of simulation scenarios regarding oil developments and policy responses to these are identified, and the steady state properties of the model for key macroeconomic variables using this numerical procedure identified. Dynamic

stability

of the model

The model must exhibit dynamic properties which are consistent with the underlying behavioural assumptions of it. The dynamic equations of the model consist of a set of endogenous control variables, namely real money balances (I), foreign asset stocks (S), capital stock (k), Tobin’s q (q) and the real exchange rate (c). The first three of these, because of assumed stickiness of price and quantity adjustment in non-financial markets, are predetermined, or nonjump, variables. The latter two variables, because they are determined in financial markets, are nonpredetermined, jump, variables, capable of adjusting instantaneously to an exogenous shock. Denoting these variables by the vector x, a linear approximation of the model around its equilibrium solution can be written in the following form: k=Ax’+Bz z is a vector of exogenous variables, x’ denotes the deviation of x around its equilibrium value, and i is its time derivative. A and Bare parameter matrices. The stability of the model depends only upon the properties of the state matrix A. Given the size and generality of the model presented, a complete algebraic analysis of model stability based upon the characteristic equation of A is not a productive exercise. However, it is possible to derive one necessary condition for stability, in that the determinant of A should be of a particular sign. For the model under discussion to generate a stable saddlepath, based upon its underlying behavioural assumptions, there must be two unstable and positive roots associated with the nonpredetermined variables and three negative and stable roots associated with the predetermined variables. Hence the determinant of A, which gives the product

263

Oil production

und macroecononk

adjustment

Table 7. Steady state properties of model (% deviation Variable

Shock case A B c

c

PC

in lndonesiu:

C Hut-vie and A Thuhu

from base value).

f

nnf

is

JLW”

I’

k

we

0.6 - 1.3 2.5

2.9 1.6 4.3

2.9 1.6 4.3

-44.6 -58.2 -31.0

I

Case 2 A B c case 3 A B C Case 4 A, B. C

4.7 4.7 4.7

0.0 0.0 0.0

- 42.4

7.6

-54.7

7.6

- 30.2

7.5

0.5 1.2 -0.2

-11.3

0.0

~ 17.3 ~ 17.3

0.0 0.0

55.6 58.3 53.0

~ 1.7 ~ I.7 - 1.7

-11.1 -11.2 - 10.9

3.0 3.4 2.6

4.8 5.1 4.6

4.8 5.1 4.6

51.1 54. I 48.2

4.1 3.1 6.2

0.0 0.0 0.0

- 42.4 - 34.4 - 50.4

1.6 6.2 8.9

0.5 -0.3 1.2

0.6

2.9 3.2

0.5

2.9 3.2 2.1

2.7

~ 44.6 -36.5 - 52.6

- 17.3

0.0

55.6

~ 1.7

3.0

4.x

4.8

51.1

of the roots, must be negative. If this is not satisfied the model will be unstable as defined here, and the underlying dynamic adjustment will be incompatible with the behavioural assumptions of the model.

-I

I.1

0.1

Case 2: an instantaneous increase in the oil price in 11):

and unanticipated 10% (changes in 0, no change

A: g = 0.5, 7 = 0.8 routine/development expenditure B: cr= 1.0, y =0.8 all routine expenditure C: (T=O.O, 7 =0.8 all development expenditure

Simulation scenarios The results derived from the macroeconomic model developed in the previous section for various simulation scenarios are now outlined.3 The focus of these is upon analysing the effects arising from shocks to oil production and the oil price, in conjunction with various numerical values for two key policy determined parameters - namely, the proportion of government spending directed towards routine (demand) expenditure and hence the resulting proportion going on developmental (capital transfer or supply) expenditure, and the proportion of oil production used domestically rather than exported. The results derived from four simulations are presented. Case 1: an instantaneous and unanticipated 10% increase in oil production (changes in g, no change in

Case 3: an instantaneous increase in oil production in ~j): A: 0=0.5, B: a=0.5, C: a=OS,

and unanticipated 10% (no change in 0, changes

~=0.8 base case y=O.7 more exports 7 =0.9 fewer exports

Case 4: an instantaneous increase in the oil price in y):

than base case than base case

and unanticipated 10% (no change in g, changes

A: a=0.5, y=O.8 base case B: a=0.5, 1’=0.7 more exports C: a=O.S, 7 =0.9 fewer exports

than base case than base case

v): A: 0 = 0.5, I)= 0.8 routine/development expenditure B: 0 = 1.O y =0.8 all routine expenditure C: 0 = 0.0, y = 0.8 all development expenditure

3The simulation results presented were derived from a algorithm known as Saddlepoint, which was developed and Buiter [I]. It is a program for solving systems differential equations with constant coefficients, based solution provided by Blanchard and Khan [2] for the case of linear difference equations.

264

numerical by Austin of linear upon the ofsystems

A summary of the long-run steady state properties of the model for each of these cases, for selected macroeconomic variables, is contained in Table 7. The results shown in this table were derived from the estimated parameter values given in Table 8. These ensure model stability, in that the adjustment of the control variables is consistent with the model’s underlying behavioural assumptions. Each case is discussed in turn, and for brevity focus is placed upon the adjustment process for six key macroeconomic variables of particular interest ~ net foreign assets, non-oil trade balance, real exchange

Oil production

Net

foreign

md macroeconomic

assets

udjusttwent

in Indonesiu:

I

09

_4L”“,‘,,‘,,‘,,,‘,.‘,“““““~ Time

Time

8

6

Real exchange

.-it

e, YG II E z : c ..m 73 2 09

6

rate

Real

I .-F

A

I

4

5

: D 5 2

2

5 .u .m > $

0 -2

income

5 4 3 2 1

-4 Time

Time 4

4 Non-oil

.-:

E

C Huruie und A Thuha

supply

I

Capital

F

1

1

2tf

o\o

-2L’.““““““““““““““” Time

Time

Figure 3.

stock

Oil

production

Table 8. Parameter

shock (case I)“.

a Key: -

A; +

/3,,=0.3 /I,,=OX pIi=o.4 /I,(,=O.l lj)z, =0.7 /j, , = 0.7 /j4, =0.7 rII =0.5 (T>=os 0.3= 0.5 du and ;’ are policy determined parameters

C

rate, real income, stock.

values”.

x, =0.6 rz=0.2 0 = 0.7 $=0.7 6=0.7 r* = 0.05 fl,, =0.5 /I, 2= 0.4

B; +

/15z=o.7 p5,=o.5 /Is4=0.7 fl, =0.4 IL* =0.7 /!a =0.8 8, =0.7 El =0.5 E3=0.5 I, = 1.0 i, =0.5 I,=O.l q,=o.5 q3=o.5 R, = 1.0 R,= 1.0 q= 1.0 !&= 1.0

non-oil

output

supply

and capital

Case I: oil production shock There is an almost continual decline in foreign asset stocks throughout the adjustment process, reflecting current account deficits, in this case irrespective of the numerical value of 0 (proportion of government expenditure used for consumption purposes). However, it is apparent that the smaller is 0, that is the larger the capital transfer to the private sector, the smaller will be the decline in foreign asset stocks. This conclusion also holds in steady state. Hence stimulating supply rather than demand, results in an improved current account performance (Figure 3). Developments in the non-oil trade balance are very similar throughout the adjustment process, irrespective

265

state is very similar irrespective of the value of rr. Hence the factor causing the difference in the steady state performance of non-oil trade arises from the div!erging effects upon real income. As already indicated real income increases by more the smaller is cr. due to higher non-oil production (supply). Non-oil production (supply) is the key variable behind higher real income. It increases by more the smaller is CJ.This can be explained by the fact that in this situation there is a larger capital transfer to the private sector, which occurs in conjunction with a higher private sector initiated accumulation of capital stock. Both combine to stimulate non-oil output supply. Table 7 summarizes steady state developments in

of the size of cr. However, in steady state the deterioration of the non-oil trade balance is greater the smaller is cr. Two major developments are influencing the evolution of the non-oil trade balance: the real exchange rate and real income. The smaller is cr the larger the depreciation, or smaller the appreciation of the real exchange rate, contributing to improved competitiveness and non-oil trade performance. However, this is offset by a noticeably larger increase in real income, which worsens the non-oil trade balance, the smaller is CT.The simulation results suggest that the influence of real income developments tends to offset that occurring for the real exchange rate on the trade balance The depreciation of the real exchange rate in steady

50 Foreign

.-E

OP

asset

stock

1

o?

do -12L-L Time

Time

s

.a, z II

5 t

Real

exchange

Real

rate

income

-5

-10

.-5 * .m ?I -15 -0 dp -201’ Time

Time 10 : -.-

Time

Time

Figure 4. Oil price shock (case 2).

Capital

* Key: -

A: x

ES;

stock

the key variables just identified, as well as those of inflation (PC<),government spending and private sector real wealth. The major developments in the case of an oil production shock are beneficial effects upon real income, non-oil output (supply) and the private sector being greater capital stock, with these benefits the smaller is 0. The non-oil trade balance, however, shows the greatest improvement the larger is 0. It will have adverse effects upon net foreign assets and real private sector wealth, with the deterioration in these being smaller the smaller is 0. Changes in the real exchange rate and government spending are similar irrespective of the value of (T,and there is no sustained impact upon inflation. Dutch disease consequences are not likely in steady state from these results, since for the three scenarios the real exchange rate depreciates, resulting in improved competitiveness for traditional non-oil exports, and real income increases resulting in higher domestic demand. Overall non-oil output is potentially more adversely affected the larger is g, that is the more the income generated from higher oil production is used to stimulate demand rather than supply. Cusc 2: oil price shock The results for this case (Figure 4) produce notable differences from those of the previous one. Foreign asset stocks increase irrespective of the value of CJ, indicating current account surpluses, with this accumulation being marginally greater during the initial stages of the adjustment process the smaller is (T.However, towards the end of the adjustment process, and in steady state, foreign asset stock accumulation is greater the larger is G. The non-oil trade balance deteriorates continuously throughout the adjustment process to steady state, irrespective of the value of cr, with a noticeably large initial deterioration apparent. Its performance during the adjustment process is not noticeably different for various values of 0, and analysis of developments in the real exchange rate and real income shows why this is so. A smaller value of g appreciates the real exchange rate by less, but contributes to a larger initial increase in real income. Both of these effects tend to cancel each other out in terms of their effect on the non-oil trade balance. The opposite is true the larger is r~. In steady state the appreciation of the real exchange rate is identical irrespective of the value of g, but real income will be higher the larger is r~. Hence the deterioration of the trade balance is greater the larger is cr. Developments in real income largely reflect changes in non-oil output (supply). It increases noticeably more initially the lower is c, the larger the capital transfer

to the private sector, but is eventually overtaken in the situation where is larger. The larger initial output supply, where CJ=O, arises from the capital transfer itself as well as higher capital stock in the private sector. Later there is a decline in private capital stock and, in the context of the model, the capital transfer effectively falls as government spending declines. Table 7 again summarizes the long-run steady state properties of the model for this case. It suggests that the lower is 0 the higher will be foreign asset stocks and real wealth, capital stock, real income and non-oil output. However, it will contribute to a slightly worse performance in the non-oil trade balance. The real exchange rate appreciates considerably, irrespective of the value of cr. and government spending falls. In the case where 6= I this latter development reduces non-oil demand, whilst in the case where 0 =0 this reduces non-oil supply. These results suggest that Dutch disease consequences, over the long run, are possible in the case of an oil price shock, unlike that of an oil production shock. The sizeable appreciation of the real exchange rate will result in a loss of competitiveness for traditional non-oil exports; however, an absolute decline in this production is not inevitable since the increase in real income is likely to stimulate demand for it. Hence in the case of Indonesia’s traditional exporting sector, agriculture, its export performance is likely to deteriorate, reflected in a declining relative share of total exports, as observed in an earlier section, while its absolute production will increase if the real income effect is sufficiently strong. However, its relative contribution to total production is likely to decline. Cuse 3: oil production shock This case (Figure 5) is concerned with analysing alternative policies in regard to oil production, specifically concerned with its domestic usage versus its usage for export. The relevant policy parameter in this regard is 1’(proportion of oil output which is used domestically). In the base case y =0.8, as in case 1 discussed previously. However, a more export oriented policy towards oil production would be equivalent to a decline in ;‘, or vice versa for a less export oriented policy. As in case 1, an oil production shock (positive) contributes to a decline in foreign asset stocks. Should the government adopt a more export orientated approach, ~=0.7, the decline in foreign asset stocks would be noticeably less, and vice versa for a less export oriented policy. Developments in the non-oil trade balance indicate more oil exports will cause a larger deterioration in this balance, brought about by a larger appreciation (or smaller depreciation) of the

267

10 Foreign

.-2

asset

stock

Non-oil

trade

balance

Time

Time 6 .-2

+

Real

exchange

rate

Real

income

$ -41..1..‘...” Time

Capital

Time

Figure 5. Oil production A; it B; + Key: b

Time

shock (case 2). C

real exchange rate and, although not initially, real income increases by more. Non-oil production increases less initially in the case where more oil is exported, despite the capital stock in the private sector increasing by more. The reason for this apparent contradiction lies in the fact that in the model government revenue, and hence spending, arises from sales of oil within the domestic economy. Oil exports generate foreign assets which are assumed to be dispersed to the private sector. Hence more oil exports imply less domestically generated revenues directly to the government, and therefore a smaller capital transfer to the private

268

stock

sector. This contributes to the discrepancy in performance of non-oil production. Reference to Table 7 indicates the long-run steady state properties of the model for different presumed values of ;‘. From this it can be concluded that such an oil shock, in conjunction with expanded oil exports, contributes to an improved performance in the current account, reducing the decline in foreign asset stocks which in turn also reduces the decline in private sector wealth. In addition real income increases by more, as does the capital stock and non-oil production. The non-oil trade balance however deteriorates by more. The real exchange rate depreciates by less, and

Oil production 50

Foreign

aJ

asset

md m~croeconon~ic

stock

udjustmmt

Non-oil

I

c+P

exchange

trade

balance

Time

Time

Real

in Indonesirr: C Hurvie mnd A Thuha

rate

-2OL”.“.““““““““““““‘CI Time

Time

3.0

Non-oil

.-F

1

Capital

supply

sfock

“I

Time

Figure 6. Oil production

Key: -

A; --it

B; +

1:

Time

shock (case 4). C

government spending increases by less. There is no sustained impact upon inflation. Hence expanding oil exports in a period of rising oil production can produce potentially advantageous developments over the longer run.

the results are equivalent to those derivable for the case of an oil price increase alone. The simulation results reported in Figure 6 are identical to those derivable for case 2 scenario A, and are not discussed further.

Cclse 4: oil price shock This final case (Figure 6) focusing upon the impact of an oil price shock, under different values of y, produces the least interesting results. The simulation results indicate that the adjustment process for each of the major macroeconomic variables is identical, irrespective of the value of 6. This is not surprising, since for the three scenarios conducted oil production and hence oil exports remain unchanged. Therefore

Summary and conclusions This paper has presented an overview of macroeconomic developments in Indonesia over the period 1970-91. In doing so we concluded that the influence of the oil sector has been significant, and there is evidence to support the existence of a Dutch disease effect having taken place for that economy in regard

269

to the agricultural sector. The oil sector has contributed substantially to structural developments in the economy, which has been greatly influenced by the way in which the government has utilized the oil revenues generated. The theoretical model presented and its numerical solution, both for steady state and during the adjustment process, for oil related shocks, produced some interesting differences. Focusing upon the issue of the Dutch disease, we concluded that any adverse effects upon Indonesia’s traditional export sector is likely to have arisen not from additional oil production but rather due to price developments. In the oil production shock case Dutch disease consequences were likely to be less the smaller the value of rr, while the opposite was true for an oil price shock. Here a lower CJ produced a similar sizeable appreciation of the real exchange rate, but smaller increase in real income and hence demand. A more export oriented policy (smaller y) towards oil output, in the case of an oil production shock, improved the performance of a number of the macroeconomic variables, with the exception of the trade balance. Dutch disease consequences arising from greater oil exports were again not strongly supported. For the oil price shock case, for various values of y, no difference in either the long-run steady state or adjustment process was apparent.

References ]

G

p Austin

Prqrum

270

and W H Buiter, Suddqwint: .4 .fur Soicing Continuous Time Lineur Rationul

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