What is the Balassa-Samuelson Effect?

The Balassa-Samuelson Effect is an effect that describes the relationship between an increase in productivity, higher exchange rates and an increase in wage growth. This effect shows that when there is an increased level of productivity in the tradable goods sector of a country, there tends to be a higher exchange rate, consumer prices are also likely to be higher. This effect is also expressed in an increase in wages. Bela Balassa and Paul Samuelson were the proponents of the Balassa-Samuelson Effect. The effect was proposed in 1963.

Why is the Balassa-Samuelson Effect Important?

The Balassa-Samuelson Effect suggests that due to the productivity biases experienced by countries, consumer prices are likely to be higher in developed countries than in developing economies. Also, given that high productivity in the tradeable goods sector causes a ripple effect in the real exchange rates, wages and consumer prices, the Balassa-Samuelson Effect maintains that inflation rates in fast-growing countries are higher than that of slow-growing economies. The rationale behind the Balassa-Samuelson Effect is that when a country becomes more productive by using land, capital and labor resources efficiently, an increase in wages and higher real exchange rate occurs. Essentially, when people earn higher wages, they tend to consume more goods and services, thereby causing the prices of goods and services to also increase.

How the Balassa-Samuelson Effect Holds up Developing Countries

Typically, the Balassa-Samuelson Effect maintains that inflation rates are higher in developed countries than in developing countries. However, as developing countries experience higher productivity in the tradable and non-tradable goods (service) sector, there is an increase in wages. But when an increase in wages is not proportional to the increase in productivity, that is an increase in wages is slower, developing countries find themselves in a situation where they produce more goods than they can consume. The logic behind this simple, when the productivity of a country increases but is not matched by a proportional increase in wages, the purchasing power of individuals is limited. Hence, despite that there goods and services as sufficiently produced in the country consumers do not have the equal purchasing power to consume them. Also, when wages grow faster than productivity, there are fewer goods and services than what they can consume.

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