Introduction

It is evident that economic conditions in Indonesia have been tied to the rise and fall of oil prices. The rapid fluctuations in oil prices resulted in considerable adjustment problems for the country. Although adjustment problems related to falling oil prices are the main preoccupation of economists these days, this paper will focus on understanding the nature of the adjustment problems that occurred during the oil boom period, with attention to the deterioration of the nonoil traded goods sector.

Substantial increases in oil prices in the 1970s provided windfall revenues to small net oil-exporting countries such as Indonesia. However, the sudden increase in oil revenues was accompanied by considerable adjustment problems related to the absorption of oil revenues into the domestic economy. The increased domestic spending placed upward pressure on the price of nontraded goods and resulted in a decline in the price of nonoil traded goods relative to the price of nontraded goods. In turn, the change in relative prices led to resource movement from the nonoil traded goods sector to the nontraded goods sector. The deterioration of this sector has been referred to as the “Dutch disease” in reference to the adjustment problems faced by the Dutch in the 1960s as a result of the Sclochteren natural gas discoveries (Neary 1984).

One of the main justifications for the 10 percent devaluation of the rupiah by the Indonesian government in 1978 was to reverse this relative price movement and thereby protect the nonoil traded goods sector. The argument was that the nonoil traded goods sector had to be protected since oil was a depletable resource that would run out in time and that the nonoil traded goods sector would then have to provide the foreign exchange needed for continued development.

The aim of this paper is to present a model to test for the Dutch disease in the case of Indonesia over the oil boom period of 1973-82. The results of the model will enable some policy recommendations to be made.

The Model

The model attempts to analyze the effects of an oil boom on sectoral outputs in a small open-economy context. The model does not consider the effects on factor returns (i.e., income distribution effects) or the issue of optimal depletion of resources. As with other models on the Dutch disease, we have adopted the small open economy, nontraded and traded goods framework of analysis.