Balassa-Samuelson effect

The Balassa-Samuelson effect is either of two related things:

Alternative, and additional causes of the Penn effect

Most professional economists accept that the Balassa-Samuelson effect model has some merit. However other sources of the RER/GDP relationship have been proposed:

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The distribution sector

In a 2001 IMF working paper Macdonald & Ricci accept that relative productivity changes produce PPP-deviations, but argue that this is not confined to tradables versus non-tradable sectors. Quoting the abstract: "an increase in the productivity and competitiveness of the distribution sector with respect to foreign countries leads to an appreciation of the real exchange rate, similarly to what a relative increase in the domestic productivity of tradables does".

Related Topics:
2001 - IMF

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The Dutch Disease

Capital inflows (say to the Netherlands) may stimulate currency appreciation through demand for money. As the RER appreciates, the competitiveness of the traded-goods sectors falls (in terms of the international price of traded goods).

Related Topics:
Netherlands - Currency - Money

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In this model, there has been no change in real economy productivities, but money price productivity in traded goods has been exogenously lowered through currency appreciation. Since capital inflow is associated with high-income states (e.g Monaco) this could explain part of the RER/Income correlation.

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Yves Bourdet and Hans Falck have studied the effect of Cape Verde remittances on the traded-goods sector (http://virtualcapeverde.net/news2/modules/Downloads/docs/emigration_dutch_disease.pdf). They find that, as local incomes have risen with a doubling of remittances from abroad, the Cape Verde RER has appreciated 14% (during the 1990s). The export sector of the Cape Verde economy suffered a similar fall in productivity during the same period, which was caused entirely by capital flows and not by the BS-effect2.

Related Topics:
Yves Bourdet - Hans Falck - Cape Verde - Remittance - RER - 1990 - 2

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A demand side explanation

The Penn effect PPP-deviation can be derived from the demand side of the economy, rather than the Balassa-Samuelson supply side model, in a similar way to the Dutch Disease explanation above.

Related Topics:
Demand - Supply - Dutch Disease

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When any non-tradable comes up for sale, its price will be determined by the relative preference between it and money by the average market consumer. By definition, high income consumers have more money, and are indifferent at a higher sale prices between buying an item and not doing so, relative to consumers in a low income area. In tradable goods, supply could shift from poor regions to rich to take advantage of this, forcing price convergence. However, non-tradable supply cannot do this, by definition. Therefore, price differences are caused (in this model) by nothing but relative differences in the abundance of money.

Related Topics:
Preference - Money - Indifferent

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In this demand-side model, the initial sources of income difference are treated as given. (Income is either exogenous or evolves based on the ability to sell non-tradables at higher prices where incomes are higher.) This model leads to random walk RER behaviour, as the exogenous rich trickle their wealth down to nearby workers without requiring them to improve productivity (the rich simply bid up local service prices). Charging what the market will bear creates the PPP-deviation in a similar way to the Balassa-Samuelson effect, but doesn't explicitly rely on productivity differentials or the changes in them.

Related Topics:
Exogenous - Random walk - PPP

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Services are a 'superior good'

Rudi Dornbusch (1998) and others say that income rises can change the ratio of demand for goods and services (tradable and non-tradable sectors). This is because services tend to be superior goods, which are consumed proportionately more heavily at higher incomes.

Related Topics:
Rudi Dornbusch - 1998 - Superior goods

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A shift in preferences at the microeconomic level, caused by an income effect can change the make-up of the consumer price index to include proportionately more expenditure on services. This alone may shift the CPI, and might make the non-trade sector look relatively less productive than it had been when demand was lower; if service quality (rather than quantity) follows diminishing returns to labour input, a general demand for a higher service quality automatically produces a reduction in per-capita productivity.

Related Topics:
Microeconomic - Income effect - Price index - Services - CPI

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A typical labour market pattern is that high-GDP countries have a higher ratio of service-sector to traded-goods-sector employment than low-GDP countries. If the traded/non-traded consumption ratio is also correlated with the price level the Penn effect would still be observed with labour productivity rising equally fast (in identical technologies) between countries.

Related Topics:
GDP - Penn effect

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The protectionism explanation

Lipsey and Swedenborg (1996) show a strong correlation between the barriers to Free trade and the domestic price level. If wealthy countries feel more able to protect their native producers than developing nations (e.g. with tarrifs on agricultural imports) we should expect to see a correlation between rising GDP and rising prices (for goods in protected industries - especially food).

Related Topics:
1996 - Free trade - Price level - Developing nation - Tarrif - GDP

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This explanation is similar to the BS-effect, since an industry needing protection must be measurably less productive in the world market of the commodity it produces. However, this reasoning is slightly different from the pure BS-hypothesis, because the goods being produced are 'traded-goods', even though protectionist measures mean that they are more expensive on the domestic market than the international market, so they will not be "traded" internationally3.

Related Topics:
Commodity - Traded - 3

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