The Balassa–Samuelson Effect is a prominent concept in international economics that explains systematic differences in price levels and real exchange rates across countries, particularly between economies at different stages of economic development. It belongs to the broader field of International Economics, linking productivity growth, wages, and inflation to the relative prices of goods and services.
What Is the Balassa–Samuelson Effect?
The Balassa–Samuelson Effect posits that countries with higher productivity growth in their tradable goods sector—such as manufacturing and agriculture—tend to experience an appreciation of their real exchange rate and a higher overall price level compared to countries with lower productivity growth. This phenomenon highlights why consumer prices are often systematically higher in more developed economies than in less developed ones. It is a key explanation for deviations from Purchasing Power Parity (PPP).
This effect operates by influencing the relative prices of goods that can be traded internationally versus those that cannot. As productivity advances disproportionately in the tradable sector, it drives up wages in that sector. Due to labor mobility, these higher wages spill over into the non-tradable goods sector, like services, where productivity gains are typically slower. Since services and other non-tradable goods cannot be easily imported to offset rising domestic costs, their prices increase, leading to a rise in the overall domestic price level.
History and Origin
The theoretical framework for what became known as the Balassa–Samuelson Effect was independently proposed by Hungarian economist Béla Balassa and American economist Paul Samuelson in 1964. Their work provided an economic explanation for an empirical observation known as the "Penn Effect," which showed that national price levels were positively correlated with per capita income across countries. Prior to their contributions, the relationship between productivity, price levels, and exchange rates lacked a comprehensive theoretical underpinning. Balassa and Samuelson formalized the mechanism through which differences in sectoral productivity growth influence a country's overall price level and its real exchange rate.
Key Takeaways
- The Balassa–Samuelson Effect explains why prices are generally higher in more economically developed countries.
- It is driven by faster productivity growth in the tradable goods sector compared to the non-tradable goods sector.
- Rising wages in the tradable sector spill over to the non-tradable sector, where slower productivity growth leads to higher prices.
- This results in an appreciation of the real exchange rate and higher domestic inflation rates in faster-growing economies.
- The effect implies that for countries experiencing rapid economic development, higher inflation may be a natural consequence of their convergence.
Formula and Calculation
While not a simple plug-and-play formula, the Balassa–Samuelson Effect can be conceptualized through the interaction of a few key economic relationships. The underlying mechanism links the relative productivity of two sectors within an economy (tradable and non-tradable) to changes in their relative prices and, ultimately, the overall price level and real exchange rate.
Consider an economy with two sectors: a tradable goods sector (T) and a non-tradable goods sector (NT). Assume that:
- Wage Equalization: Due to perfect labor mobility, wages ((w)) are equalized across both sectors within a country.
( w = P_T \cdot MPL_T = P_{NT} \cdot MPL_{NT} )
where (P_T) and (P_{NT}) are the prices of tradable and non-tradable goods, respectively, and (MPL_T) and (MPL_{NT}) are the marginal products of labor in the tradable and non-tradable sectors. - Law of One Price for Tradables: Prices of traded goods tend to be equalized across countries, adjusted for the nominal exchange rate and transport costs.
( P_T = E \cdot P_T* ) (where (E) is the nominal exchange rate and (P_T*) is the foreign price of tradables). - Aggregate Price Level: The overall domestic price level ((P)) is a weighted average of tradable and non-traded goods prices.
( P = P_T\alpha P_{NT}{1-\alpha} ) (where (\alpha) is the share of tradables in the consumption basket).
From wage equalization, we can derive the relative price of non-tradables to tradables:
( \frac{P_{NT}}{P_T} = \frac{MPL_T}{MPL_{NT}} )
If a country experiences faster labor productivity growth in its tradable sector ((MPL_T)) than in its non-tradable sector ((MPL_{NT})), the ratio ( \frac{MPL_T}{MPL_{NT}} ) increases. This implies that the relative price of non-tradable goods ((P_{NT}/P_T)) must rise. Since tradable goods prices are globally determined, this rise in (P_{NT}) leads to an increase in the overall domestic price level ((P)). Consequently, with the nominal exchange rate relatively stable or appreciating less than the price differential, the country's real exchange rate appreciates.
Interpreting the Balassa–Samuelson Effect
Interpreting the Balassa–Samuelson Effect involves understanding its implications for economic policy and international comparisons. When a country experiences a strong Balassa–Samuelson Effect, it means that its rapidly advancing tradable sectors are boosting overall economic output and living standards. However, this growth also translates into higher domestic prices for services and other non-tradable goods.
For policymakers, this implies that a certain level of higher inflation in fast-growing economies, especially emerging markets, is a natural consequence of their convergence towards the productivity levels of more developed economies. Trying to suppress thi8s inflation through tight monetary policy might unduly hamper economic growth and competitiveness. Central banks in such economies often face a "dilemma" where their inflation targets may be difficult to achieve without significant nominal exchange rate appreciation. The Bank for International Settlements (BIS), for example, has analyzed this effect in Central European countries in the context of their readiness for European monetary union membership, where higher inflation rates could be a natural result of the Balassa–Samuelson effect as these economies converge with the Euro area.
Hypothetical Example7
Consider two hypothetical countries, Alpha and Beta, both producing tradable goods (e.g., electronics) and non-tradable services (e.g., haircuts).
Year 1:
- Alpha: Productivity in electronics is moderate, productivity in haircuts is low.
- Beta: Productivity in electronics is also moderate, productivity in haircuts is low.
- Wages are comparable in both countries, and overall price levels are similar.
Year 10:
- Alpha: Experiences rapid technological advancement and investment in its electronics sector, leading to significant labor productivity gains. Its electronics become cheaper to produce. Wages in the electronics sector rise due to increased productivity and demand for skilled labor. Due to competition for labor, wages in Alpha's haircut sector also rise, even though there have been no significant productivity improvements in haircuts (a barber still takes roughly the same time to cut hair).
- Beta: Has modest productivity gains in both sectors.
Outcome:
Because electronics (tradable goods) prices in Alpha are largely determined by global markets (and thus are similar to Beta's internationally), the rising wages in Alpha mean that Alpha's domestic haircut prices (non-tradable goods) increase substantially more than Beta's. Consequently, while Alpha's citizens can buy electronics at competitive international prices, their domestic services become much more expensive. Alpha's overall domestic price level, largely driven by the cost of its non-tradable services, rises significantly relative to Beta's. This leads to a real appreciation of Alpha's currency, even if its nominal exchange rate hasn't changed dramatically.
Practical Applications
The Balassa–Samuelson Effect has several practical applications in understanding global economic phenomena and informing policy:
- Explaining Price Level Differences: It provides a key explanation for why high-income countries tend to have higher aggregate price levels than low-income countries, a persistent empirical observation. This is evident to travelers who find local services more expensive in richer nations.
- Real Exchange Rate Dynamics: It is a significant factor in explaining long-run movements and appreciation of the real exchange rate, especially for economies undergoing rapid development and convergence.
- Inflation Targeting: For central banks in emerging economies, understanding the Balassa–Samuelson Effect is crucial. The structural inflation stemming from the effect can mean that targeting very low inflation rates, similar to advanced economies, might require an undesirably large real appreciation or could impede genuine economic growth.
- International Comparisons: When comparing economic indicators like Gross Domestic Product (GDP) across countries, the Balassa–Samuelson Effect underscores why using Purchasing Power Parity (PPP) exchange rates often provides a more accurate picture of living standards than market exchange rates. The International Monetary Fund (IMF) and other organizations use PPP-adjusted figures to make more meaningful international comparisons of economic output.
- Balance of Payments Anal6ysis: The effect indirectly influences a country's Balance of Payments by affecting its terms of trade and competitiveness. While not directly a component of the Current Account or Capital Flows, the real exchange rate movements it generates impact trade balances and capital movements over time.
Limitations and Criticisms
Despite its explanatory power, the Balassa–Samuelson Effect faces several limitations and criticisms:
- Empirical Evidence Variability: While the core prediction of a positive relationship between productivity differentials and real exchange rate appreciation is widely accepted, the strength and consistency of empirical evidence vary across countries and time periods. Some studies find weak or inconsistent support, especially in time-series data or for very high-income countries.
- Assumptions: The model r5elies on strong assumptions, such as perfect labor mobility and the strict adherence of tradable goods prices to the Law of One Price. In reality, labor markets can be rigid, and transport costs, trade barriers, and product differentiation can lead to significant deviations from the Law of One Price for tradables.
- Other Factors: Critics a4rgue that other factors, such as demand shifts, changes in the terms of trade, capital account liberalization, and differences in consumption patterns, can also significantly influence real exchange rates and price levels, potentially overshadowing or interacting with the Balassa–Samuelson Effect.
- Dutch Disease: While disti3nct, the Balassa–Samuelson Effect shares some similarities with the concept of "Dutch Disease," where a boom in one tradable sector (e.g., natural resources) leads to currency appreciation and deindustrialization in other tradable sectors. However, the Balassa–Samuelson Effect refers to general, broad-based productivity growth, not a specific resource boom.
- Measurement Challenges: Accurately measuring productivity differentials between tradable and non-tradable sectors, especially in developing countries, can be challenging due to data limitations and definitional complexities.
A comprehensive survey of empirical e2vidence, such as "The Harrod-Balassa-Samuelson Effect: A Survey of Empirical Evidence" by Tica and Družić, highlights these complexities and the ongoing debate among economists regarding the effect's significance and empirical verification.
Balassa–Samuelson Effect vs. Purchas1ing Power Parity
The Balassa–Samuelson Effect and Purchasing Power Parity (PPP) are closely related but distinct concepts. PPP is a theory that suggests that the exchange rate between two currencies should equalize the price of a basket of identical goods and services in both countries. In its absolute form, it implies that, after converting currencies, the same goods should cost the same everywhere.
The Balassa–Samuelson Effect, however, provides a systematic reason why absolute PPP often does not hold between countries, particularly when comparing economies with different productivity growth rates. While the Law of One Price is assumed to broadly hold for traded goods, the effect explains that faster productivity growth in the tradable sector of a developing country drives up its domestic wages. These higher wages then translate into higher prices for non-traded goods (like services), where productivity gains are slower. Since the overall price level includes both tradable and non-tradable goods, the total cost of a basket of goods and services will be higher in the more productive, faster-growing economy. Therefore, the market nominal exchange rate will not fully equalize these overall price levels, leading to a real exchange rate appreciation and a deviation from PPP. In essence, the Balassa–Samuelson Effect explains a reason for systematic deviations from PPP based on economic fundamentals.
FAQs
Why are prices higher in richer countries?
Prices for many goods and services tend to be higher in richer countries primarily due to the Balassa–Samuelson Effect. Richer countries typically have higher productivity in their manufacturing and other tradable goods sectors. This high productivity leads to higher wages in these sectors. Due to the movement of workers between industries, these higher wages spill over into sectors that produce non-tradable goods and services (like haircuts, restaurant meals, or local transportation), where productivity gains are harder to achieve. Since these services cannot be easily imported from cheaper countries, their prices rise, increasing the overall cost of living.
Does the Balassa–Samuelson Effect cause inflation?
Yes, the Balassa–Samuelson Effect can contribute to higher inflation rates in countries experiencing rapid economic growth. As productivity in the tradable goods sector outpaces that in the non-tradable sector, wages rise across the board. Since productivity in the non-tradable sector does not keep pace, the increased labor costs translate directly into higher prices for non-tradable goods and services, pushing up the country's overall price level. This means that faster-growing economies might naturally experience higher inflation than their slower-growing counterparts.
How does the Balassa–Samuelson Effect relate to a country's currency?
The Balassa–Samuelson Effect implies that countries with higher relative productivity in their tradable sectors will experience an appreciation of their real exchange rate. This means their currency can buy more foreign goods and services, or equivalently, that foreign currencies can buy less of that country's goods and services when adjusted for price levels. In simpler terms, their currency appears stronger in real terms due to their higher domestic price level, especially for services, compared to their trading partners.