RDP 2013-14: Reserves of Natural Resources in a Small Open Economy 1. Introduction

Large movements in commodity prices over the past decade have spurred renewed interest in the effects of commodity price shocks on a small open economy. One group of commodities that has received increasing attention, especially in the Australian case, is non-renewable resource commodities such as iron ore, coal and natural gas. We refer to this class of commodities as natural resources.^[1]

Recent literature has studied the effects of shocks to the average price of natural resources by integrating a resource sector within a small open economy dynamic stochastic general equilibrium (DSGE) model. This approach provides a structural framework for studying the general equilibrium effects of these shocks, including their feedback effects and policy implications in a small open economy.

This paper adds to that work by assuming that the stock of domestic natural resource reserves is endogenous, rather than held constant as assumed in previous literature. Specifically, we allow firms to have access to an exploration technology, that can be used to increase reserves, and we assume that firms account for the effects of current extraction on the future availability of reserves (depletion). These two effects have been ignored in previous DSGE models with a natural resource sector.

Our findings suggest that allowing for endogenous reserves has substantial effects on the magnitude and persistence of the resource sector's response to a price shock in both partial and general equilibrium. The mechanism at the core of our model, the ability to accumulate newly discovered reserves through exploration, implies that resource firms respond to a price shock by increasing both extraction and exploration. Exploration that results in newly discovered reserves, in turn, leads to a permanent increase in firms' future extraction possibilities. These additional reserves provide firms with the incentive to use more labour, and increase investment and extraction by more than in the case in which reserves are held fixed.

The larger expansion of the resource sector also has implications for the domestic allocation of goods. We find that when reserves are endogenous, there is a greater reallocation of goods between sectors in response to a resource price shock. In particular, more inputs, that would otherwise be used in the production of goods for consumption and non-resource exports, are redirected towards the resource sector where demand is stronger. However, total domestic production – measured as a weighted sum of domestic intermediate value added – is little changed relative to baseline. This is because slower growth of consumption and non-resource demand is largely offset by stronger growth in demand from the resource sector.

When comparing the behaviour of consumer prices, the real exchange rate and domestic interest rates, we find that the effects of a resource price shock are similar irrespective of whether we assume an endogenous or exogenous stock of natural resources. This suggests that the standard approach of assuming exogenous reserves can still provide a useful approximation for quantifying the price effects associated with a resource price shock.

The rest of the paper is organised as follows. Section 2 outlines our motivation and provides some simple stylised facts on the effects of a resource price shock. These stylised facts are used to help calibrate the partial and general equilibrium models that we discuss in Sections 3 and 4. Section 5 discusses the robustness of our findings in terms of identification – the mapping between our theoretical and empirical models – and whether the results are sensitive to the structure of the empirical VAR we estimate. Some conclusions from our work are drawn in Section 6.

Footnote

Throughout the paper we use the term ‘natural resources’ synonymously with non-renewable natural resources and abstract from renewable natural resources. [1]