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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.
A Little More on What is the Balassa-Samuelson Effect
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.
Reference for “Balassa-Samuelson Effect”
Academic research on “Balassa-Samuelson Effect”
The Balassa–Samuelson effect in Central and Eastern Europe: myth or reality?, Égert, B., Drine, I., Lommatzsch, K., & Rault, C. (2003). The Balassa–Samuelson effect in Central and Eastern Europe: myth or reality?. Journal of comparative Economics, 31(3), 552-572. This paper studies the Balassa–Samuelson effect in nine Central and East European countries. Using panel cointegration techniques, we find that the productivity growth differential in the open sector leads to inflation in non-tradable goods. Because of the low share of non-tradables and the high share of food items in addition to regulated prices, the consumer price index is misleading when analyzing the Balassa–Samuelson effect. Consequently, the appreciation of the real exchange rate, which has been established as a stylized fact over the last decade, is caused only partly by the Balassa–Samuelson effect. We identify a trend increase in the prices of tradable goods as a contributing explanation.
The Balassa–Samuelson effect in central Europe: a disaggregated analysis, Mihaljek, D., & Klau, M. (2004). The Balassa–Samuelson effect in central Europe: a disaggregated analysis. Comparative Economic Studies, 46(1), 63-94. This paper aims to explain differences in inflation between six central European economies – Croatia, the Czech Republic, Hungary, Poland, Slovakia and Slovenia – and the euro area in terms of differences in productivity growth between tradable and non-tradable sectors. The coverage of tradable and non-tradable sectors is broader and more detailed than in previous studies and the data samples are larger, as quarterly data for up to 10 years are used. The main conclusion is that productivity differentials explain on average only between 0.2 and 2.0 percentage points of annual inflation differentials vis-à-vis the euro area. Productivity differentials also explain only a small proportion of domestic inflation in central European economies. Earlier studies that estimated the Balassa–Samuelson effect to be larger have often neglected to consider the impact of productivity differentials on inflation relative to the euro area, focusing instead only on their impact on domestic inflation. Many studies have also neglected the relatively high productivity growth in non-tradable industries. The estimates in this paper suggest that differences in productivity growth between EU accession countries and the euro area are unlikely to widen sufficiently to become a determining factor in the ability of these countries to satisfy the Maastricht inflation criterion.
Real exchange rates over the past two centuries: how important is the Harrod‐Balassa‐Samuelson effect?, Lothian, J. R., & Taylor, M. P. (2008). Real exchange rates over the past two centuries: how important is the Harrod‐Balassa‐Samuelson effect?. The Economic Journal, 118(532), 1742-1763. Using data since 1820 for the US, the UK and France, we test for the presence of real effects on the equilibrium real exchange rate (the Harrod‐Balassa‐Samuelson, HBS effect) in an explicitly nonlinear framework and allowing for shifts in real exchange rate volatility across nominal regimes. A statistically significant HBS effect for sterling–dollar captures its long‐run trend and explains a proportion of variation in changes in the real rate that is proportional to the time horizon of the change. There is significant evidence of nonlinear reversion towards long‐run equilibrium and downwards shifts in volatility during fixed nominal exchange rate regimes.
Estimating the impact of the Balassa–Samuelson effect on inflation and the real exchange rate during the transition, Égert, B. (2002). Estimating the impact of the Balassa–Samuelson effect on inflation and the real exchange rate during the transition. Economic Systems, 26(1), 1-16. In this paper, we investigate whether the Balassa–Samuelson (B–S) effect holds for the Czech Republic, Hungary, Poland, Slovakia and Slovenia during the transition process. The co-integration analysis suggests that the importance of the B–S effect does differ across countries. Generally, we can establish long-term co-integration relationships between productivity growth and relative prices while the link between relative price movement and the Real Exchange Rate Developments turns out to be weaker. We seek to calculate the extent to which the B–S effect may influence inflation and the real exchange rate and subsequently discuss policy implications.
The real exchange rate and the Balassa–Samuelson effect: the role of the distribution sector, MacDonald, R., & Ricci, L. A. (2005). The real exchange rate and the Balassa–Samuelson effect: the role of the distribution sector. Pacific Economic Review, 10(1), 29-48. This paper investigates the long‐run impact of the distribution sector on the real exchange rate. The main result is that an increase in the productivity and product market competition of the distribution sector with respect to foreign countries leads to an appreciation of the real exchange rate, similar to what a relative increase in the domestic productivity of tradables does. This contrasts with the result that one would expect by considering the distribution sector as belonging to the non‐tradable sector. One explanation may lie in the use of the services from the distribution sector in the tradable sector.