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has often recommended resource rich countries to put their windfalls in a sovereign wealth
fund (e.g., Davis et al., 2002). Fig. 6 shows how the permanent income hypothesis and the
consequent building up of such a fund are used to optimally harness unanticipated windfalls.
In practise countries such as Norway prefer to restrict incremental consumption to interest
earned on the fund and not to use the windfall until it is banked, which gives the conservative
bird-in-hand rule. Estimation of fiscal reaction functions for non-hydrocarbon tax and public
spending using official projections for hydrocarbon revenues and the pension burden for
Norway suggests that fiscal reactions have been partially forward-looking with respect to the
pension bill, but indeed not with respect to hydrocarbon revenues (Harding and van der Ploeg,
2009). The primary non-hydrocarbon deficit should according to the permanent income
hypothesis react only to permanent oil/gas revenues, but in practise it also reacts to current
revenues. This suggests that Norway has used the bird-in-hand rule rather than the permanent
income rule. VAR analysis of a DSGE model of oil-rich economies with a traded and non-
traded sector suggests that the fiscal rules of Mexico and Norway with respectively a small
and big emphasis on saving windfalls can explain the Mexican hump-shaped impulse
responses for output, the real exchange rate and private consumption and the flat responses
for Norway (Pieschacon, 2009). More DSGE work is needed on resource rich economies, also
paying attention to monetary policy rules, sterilization of foreign exchange windfalls and
unemployment in the light of natural resource windfalls.
One must take account of the special features of resource rich developing countries.
Many of them are converging on a development path, suffer capital scarcity and high interest
rates resulting from premium on high levels of foreign debt, and households do not have
access to perfect capital markets. In that case, the permanent income hypothesis is
inappropriate. In contrast to transferring much of the increment to future generations (as with
the permanent-income and bird-in-hand rules), the optimal time path for incremental
consumption should be skewed towards present generations and saving should be directed
towards accumulating of domestic private and public capital and cutting debt rather than
accumulating foreign assets (van der Ploeg and Venables, 2010a). The resulting optimal
micro-founded path for incremental consumption is given in fig. 6. Effectively, the windfall
brings forward the development path of the economy. Although the hypothesis of learning-
by-doing in the traded sector may be relevant for advanced industrialised economies,
developing economies are more likely to suffer from absorption constraints in the non-traded
sector especially as it is unlikely that capital in the traded sector can easily be unbolted and
shunted to the non-traded sector. This cuts the other way, since it is then optimal to
temporarily park some of the windfall in a sovereign wealth fund until the non-traded sector
has produced enough home-grown capital (infrastructure, teachers, nurses, etc.) to alleviate
absorption bottlenecks and allow a gradual rise in consumption (see appendix 4). The