What is the Balassa-Samuelson effect?
The Balassa-Samuelson effect indicates that the differences in productivity between the production of tradable goods in different countries 1) explain the large differences observed in wages and in the price of services and between purchasing power parity and exchange rate, and 2) it means that the currencies of the more productive countries will appear undervalued in terms of exchange rates; this gap will increase with higher incomes.
The Balassa-Samuelson effect suggests that an increase in wages in the tradable goods sector of an emerging economy will also lead to higher wages in the non-tradable (service) sector of the economy. The accompanying rise in prices makes inflation rates higher in fast-growing economies than in slow-growing developed economies.
Key points to remember
- The Balassa-Samuelson explains the price and income differences between countries due to differences in productivity.
- It also explains why using exchange rates against purchasing power parity to compare prices and incomes across countries will give different results.
- This implies that the optimal rate of inflation will be higher for developing countries as they grow and increase their productivity.
Understanding the Balassa-Samuelson effect
The Balassa-Samuelson effect was proposed by economists Bela Balassa and Paul Samuelson in 1964. It identifies differences in productivity as the factor that leads to systematic differences in prices and wages between countries, and between expressed national incomes. using exchange rates and purchasing power parity (PPP). These differences were previously documented by empirical data collected by researchers at the University of Pennsylvania and are easily observed by travelers between different countries.
According to the Balassa-Samuelson effect, this is due to differences in productivity growth between market and non-market sectors in different countries. High-income countries are more technologically advanced, and therefore more productive, than low-income countries, and the advantage of high-income countries is greater for tradable goods than for non-tradable goods. According to the law of one price, the prices of tradable goods should be equal between countries, but not for non-tradable goods. Higher productivity of tradable goods will translate into higher real wages for workers in that sector, resulting in higher relative prices (and wages) for the local nontradables that these workers buy. Therefore, the difference in long-run productivity between high-income and low-income countries results in trend deviations between exchange rates and PPP. It also means that countries with low per capita income will have lower domestic prices for services and lower price levels.
The Balassa-Samuelson effect suggests that the optimal rate of inflation for developing economies is higher than for developed countries. Developing economies grow by becoming more productive and by using land, labor and capital more efficiently. This translates into wage growth in both tradable and non-tradable goods components of an economy. People consume more goods and services as their wages increase, which pushes up prices. This implies that an emerging economy that grows by increasing its productivity will experience higher prices. In developed countries, where productivity is already high and not increasing as quickly, inflation rates are expected to be lower.