Balassa-Samuelson effect

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

Empirical evidence on the Balassa-Samuelson effect hypothesis

Evidence for the Penn effect is well established in the modern era (and is readily observable when traveling internationally). However, econometric evidence that the BS-effect is the mechanism causing the CPI differentials is much less easy to obtain.

Related Topics:
Penn effect - Econometric

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Kravis & Lipsey's 1991) review of the International Comparison Program has provided evidence that non-traded goods prices do tend to rise faster than (or relative to) traded goods prices. However, the Balassa-Samuelson (BS) hypothesis implies that countries with rapidly expanding economies should tend to have more rapidly appreciating exchange rates (for instance the Asian Tigers); conventional time series cointegration tests tend to be unable to reject the null hypothesis that there is no such link.

Related Topics:
1991 - International Comparison Program - Asian Tiger - Cointegration - Null hypothesis

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Direct tests of the connection between real exchange rates (RER)s and relative productivities are difficult to perform because of the relatively short time window for which modern-quality econometric data is available. However, these tests have been attempted, again with mixed findings for the predictions of the BS effect. Although some negative results were returned, there has been some support for the predictions of the BS-hypothesis in the literature, for instance:

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• Bahmani-Oskooe & Rhee (1996) did find a statistically significant correlation between RERs and relative productivities.
• Lafrance and Schembri (2000) (http://www.bank-banque-canada.ca/publications/review/autumn02/lafrance_e.pdf) suggest that the Balassa-Samuelson mechanism may be evident in the 1979 to 1999 productivity and exchange rate changes between the United States, and Canada. (They think it likely that Canada's lagging productivity growth in manufacturing has contributed to the CAD's RER depreciation against the USD.)

Drine & Rault (2002) argue that the difficulties of confirming the hypothesis have partly been due to testing particular components of it, and that even where the varying-productivity-RER link is established it doesn't necessarily confirm the BS-hypothesis; they analyzed its main assumptions separately:

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• The differential of productivities between traded and non-traded sector and relative prices are positively correlated.
• The purchasing power parity assumption is verified for tradable goods.
• The RER and relative prices of non-goods are positively correlated.
• As a consequence of 1, 2, & 3, there is a long-run relationship between productivity differentials and the RER.

For the six Asian economies they followed from 1983 to 1997 they find that although the RER-productivity relationship (4) appears to hold in cointegrating time-series regressions, it cannot be explained by the BS hypothesis, because the evidence rejects assumptions (2) and (3) which are the channels through which the BS-effect supposedly operates. In fact, Drine & Rault's Panel methodology revisions "indicate the absence of a significant co-integrating relationship between real exchange rate and productivity differential", in these data sets.

Related Topics:
Asian - 1983 - 1997 - Cointegrating

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Refinements to the econometric techniques and debate about alternative models are continuing in the International economics community. For instance:

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:"A possible explanation of the BS empirical rejection may simply be that there are additional long-run real exchange determinants that have to be considered." Drine & Rault conclude.

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The next section lists some of the alternative proposals to an explanation of the Penn effect, but there are significant econometric problems with testing the BS-hypothesis, and the lack of strong evidence for it between modern economies may not refute it, or imply that it produces a small effect. For instance, other effects of exchange rate movements might mask the long-term BS-hypothesis mechanism (making it harder to detect if it exists). Exchange rate movements are believed by some to have an impact on productivity; if this is true then regressing RER movements on differential productivity growth will be 'polluted' by a totally different relationship between the variables1.

Related Topics:
Penn effect - Econometric - Variable - 1

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