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Balassa-Samuelson effect

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	Topics Balassa-Samuelson effect Topic Home The Balassa-Samuelson effect (also known as Harrod-Balassa-Samuelson effect (Kravis and Lipsey 1983), the Ricardo-Viner-Harrod-Balassa-Samuelson-Penn-Bhagwati effect (Samuelson 1994, p. 201), productivity biased purchasing power parityPurchasing power parity In economics, purchasing power parity is a theory which says that the long-run equilibrium exchange rate of two currencies ... (PPP) (Officer 1976) and the rule of five eights (David 1972)) is either of two related things: The observation that consumer priceConsumer price index In economics, a consumer price index is a statistical time-series measure of a weighted average of prices of a specified set... levels in wealthier countries are systematically higher than in poorer ones (the "Penn effectPenn effect The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exa... "). An economic model predicting the above, based on the assumption that productivityProductivity In economics, productivity is the amount of output created per unit input used.... or productivity growth-rates vary more by country in the traded goods' sectors than in other sectors (the Balassa-Samuelson hypothesis). This article deals with point (2): BalassaBéla Balassa B?la Balassa was a Hungarian economist and world-renowned professor at Johns Hopkins University; most famous for his work w... and SamuelsonPaul Samuelson Paul A. Samuelson is an American economist known for his work in many fields of economics.... 's causal modelBalassa-Samuelson effect The Balassa-Samuelson effect is either of two related things:... . For a fuller description of the stylized fact it attempts to explain see: Penn effectPenn effect Summary The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exa... . The theory The Balassa-Samuelson effect (BS-effect) depends on inter-country differences in the relative productivityProductivity In economics, productivity is the amount of output created per unit input used.... of the tradable and non-tradable sectors. The empirical "Penn Effect" effect The exchange of tradableTradable A tradable good or service can be sold distant from where it is produced.... goods and services shouldLaw of one price The law of one price is an economic law stated as: "In an efficient market all identical goods must have only one price."... lead prices to converge, but convergence is only partial, because some products are not tradable, and some products are generally produced locally (e.g. bread). The Penn effect is that the RER (Real Exchange Rate) deviations usually occur in the same direction: where incomes are high, price levels, as for example measured by the Consumer Price IndexConsumer price index In economics, a consumer price index is a statistical time-series measure of a weighted average of prices of a specified set... are relatively high compared to an international average, and where they are low, they tend to be below the average. The effect in more detail A typical discussion of this argument (e.g. by Paul KrugmanPaul Krugman Paul Robin Krugman is an economist at Princeton University who has written several books and since 2000 has written a twice-... ) would include the following features: Workers in some countries have higher productivityProductivity In economics, productivity is the amount of output created per unit input used.... than in others. This is the ultimate source of the income differential. (Also expressed as productivity growth.) Certain labour-intensive jobs are less responsive to productivity innovations than others. For instance, a highly skilled Zurich burger flipper is no more productive than his MoscowMoscow Moscow is the capital of Russia and the country's principal political, economic, financial, educational, and transportation... counterpart (in burger/hour) but these jobs are services which must be performed locally. The fixed-productivity sectors are also the ones producing non-transportable goods (for instance haircuts) - this must be the case or the labour intensive work would have been off-shoredOffshoring Offshoring may be defined as the relocation of business processes from one country to another.... . To equalize local wage levels with the (highly productive) Zurich engineers, McDonalds Zurich employees must be paid more than McDonalds Moscow employees, even though the burger production rate per employee is an international constant. The CPI is made up of: local goods (which are expensive relative to tradables in rich countries) Tradables, which have the same price everywhere The (real) exchange rateExchange rate In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other.... is pegged (by the law of one priceLaw of one price The law of one price is an economic law stated as: "In an efficient market all identical goods must have only one price."... ) so that tradable goods follow PPP. The assumption that PPP holds only for tradable goods is testable. Since money exchange rates will vary fully with tradable goods productivity, but average productivity varies to a lesser extent, the (real goods) productivity differential is less than the productivity differential in money terms. Productivity becomes income, so the real income varies less than the money income does. This is equivalent to saying that the money exchange rate exaggerates the real income, or that the price level is higher in more productive, richer, economies. Equivalent 'Balassa-Samuelson effect' within a country The average asking price for a house in a prosperous city can be ten times that of an identical house in a depressed area of the same country. Therefore, the RER-deviation exists independent of what happens to the nominal exchange rate (which is always 1 for areas sharing the same currency). Looking at the price level distribution within a country gives a clearer picture of the effect, because this removes three complicating factors: The econometricsEconometrics *Econometrics* literally means 'economic measurement'.... of purchasing power parityPurchasing power parity In economics, purchasing power parity is a theory which says that the long-run equilibrium exchange rate of two currencies ... (PPP) tests are complicated by nominal exchange rateExchange rate In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other.... noise. (This noise would be an econometric problem, even assuming that the exchange rate volatility is a pure error termStandard error (statistics) In statistics, the standard error of a measurement, value or quantity is the standard deviation of the process by which it w... ). There may be some real economy border effects between countries which limit the flow of tradables or people. Monetary effects, and exchange rate movements can affect the real economy and complicate the picture, a problem eliminated if comparing regions that use the same currencyCurrency A currency is a unit of exchange, facilitating the transfer of goods and services.... unit. A pint of pub beer is famously more expensive in the south of EnglandEngland England is the largest and most populous constituent country of the United Kingdom.... than the North, but supermarket beerBeer Beer is one of the world's oldest alcoholic beverages, possibly brewed for the first time over 10,000 years ago, according t... prices are very similar. This may be treated as anecdotal evidenceAnecdotal evidence Anecdotal evidence is an informal account of evidence in the form of an anecdote, or hearsay.... in favour of the Balassa-Samuelson hypothesis, since supermarket beer is an easily transportable, traded good. (Although pub beer is transportable, the pub itself is not.) The BS-hypothesis explanation for the varying pricePrice In economics and business, the price is the assigned numerical monetary value of a good, service or asset.... differentials is that publicanPublic house A public house, usually known as a pub, is an establishment which serves alcoholic drinks for consumption on the premi... 's 'productivity' in serving customers is more uniform (in pints per hour) than is the 'productivity' (in foreign earnings per year) of people working in the exportExport In economics, an *export* is any good or commodity, transported out of a country, province or town to another part of the ... sector in either half of the country. (Reputedly Financial servicesFinancial services Financial services is a term used to refer to the services provided by the finance industry.... in the South of England, heavy industryIndustry An industry is generally any grouping of businesses that share a common method of generating profits, such as the "music ind... in the North.) The implication that one region is less 'productive' than another is politically controversial. 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 Penn effectPenn effect The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exa... RER/GDPGross domestic product A region's gross domestic product, or GDP, is one of the several measures of the size of its economy.... relationship have been proposed: The distribution sector In a 2001 International Monetary FundInternational Monetary Fund Overview The International Monetary Fund is an international organization that oversees the global financial system by observing ex... 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". The Dutch Disease Capital inflows (say to the NetherlandsNetherlands The Netherlands is the European part of the Kingdom of the Netherlands , which is formed by the Netherlands, the Neth... ) may stimulate currencyCurrency A currency is a unit of exchange, facilitating the transfer of goods and services.... appreciation through demand for moneyMoney Summary Economics offers various definitions for money, though it is now commonly considered to be any good or token that functions ... . As the RER appreciates, the competitiveness of the traded-goods sectors falls (in terms of the international price of traded goods). 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 MonacoMonaco The Principality of Monaco , more commonly known as Monaco, is a constitutional monarchy and city-state in Western Eur... ) this could explain part of the RER/Income correlation. Yves Bourdet and Hans Falck have studied the effect of Cape VerdeCape Verde The Republic of Cape Verde or Cape Verde is a republic located on an archipelago in the Macaronesia ecoregion of the ... remittances on the traded-goods sector. They find that, as local incomes have risen with a doubling of remittances from abroad, the Cape Verde RERExchange rate In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other.... 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-effect.. A demand side explanation The Penn effect PPP-deviation can be derived from the demand side of the economy, rather than the Balassa-Samuelson supplyFacts About Supply *Supply* has a number of meanings:... side model, in a similar way to the Dutch DiseaseDutch disease Dutch disease is an economic concept that tries to explain the seeming relationship between the exploitation of natural reso... explanation above. When any non-tradable comes up for sale, its price will be determined by the relative preferencePreference Preference is a concept, used in the social sciences, particularly economics.... between it and moneyMoney Overview Economics offers various definitions for money, though it is now commonly considered to be any good or token that functions ... 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. In this demand-side model, the initial sources of income difference are treated as given. (Income is either exogenousExogenous Exogenous refers to an action or object coming from outside a system.... or evolves based on the ability to sell non-tradables at higher prices where incomes are higher.) This model leads to random walkRandom walk In mathematics and physics, a random walk, sometimes called a "drunkard's walk," is a formalisation of the intuitive idea of... RER behaviour, as the exogenousExogenous Exogenous refers to an action or object coming from outside a system.... 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. The protectionismProtectionism Overview Protectionism is the economic policy of restraining trade between nations, through methods such as high tariffs on imported ... explanation Lipsey and Swedenborg (1996) show a strong correlation between the barriers to Free tradeFree trade In international trade, free trade is an idealized market model, often stated as a political objective, wherein trade of goo... and the domestic price levelConsumer price index In economics, a consumer price index is a statistical time-series measure of a weighted average of prices of a specified set... . 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 GDPGross domestic product A region's gross domestic product, or GDP, is one of the several measures of the size of its economy.... and rising prices (for goods in protected industries - especially food). This explanation is similar to the BS-effect, since an industry needing protection must be measurably less productive in the world market of the commodityCommodity The word *commodity* is a term with distinct meanings in business and in Marxian political economy.... 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 "tradedExport Overview In economics, an *export* is any good or commodity, transported out of a country, province or town to another part of the ... " internationally Trade theory implications The supply-side economistsSupply-side economics Supply-side economics is a school of macroeconomic thought which emphasizes the "supply" part of supply and demand.... (and others) have argued that raising International competitiveness through policies that promote traded goods sectors' productivity (at the expense of other sectors) will increase a nation's GDP, and increase its standard of livingStandard of living The Standard of living refers to the quality and quantity of goods and services available to people and the way these servic... , when compared with treating the sectors equally. The Balassa-Samuelson effect might be one reason to oppose this trade theory, because it predicts that: a GDP gain in traded goods does not lead to as much of an improvement in the living standard as an equal GDP increase in the non-traded sector. (This is due to the effect's prediction that the CPI will increase by more in the former case.) History The Balassa-Samuelson effect model was developed in 1964 by both Balassa BélaBéla Balassa B?la Balassa was a Hungarian economist and world-renowned professor at Johns Hopkins University; most famous for his work w... & Paul SamuelsonPaul Samuelson Paul A. Samuelson is an American economist known for his work in many fields of economics.... , working independently. It is surprising that both of these economists should have completed their models separately & simultaneously (submitting them to different economic journals) because the outlines of the explanation had been described twenty-five years earlier by Roy Forbes Harrod in "International Economics". Partly because empiricalEmpirical Summary A central concept in science and the scientific method is that all evidence must be empirical, or empirically based, t... findings have been mixed, and partly to differentiate the model from its conclusion, modern papers tend to refer to the "Balassa-Samuelson hypothesisHypothesis Overview A hypothesi is a suggested explanation of a phenomenon or reasoned proposal suggesting a possible correlation between multi... ", rather than the "Balassa-Samuelson effect". (See for instance: "", referred to above.) See also List of international trade topicsList of international trade topics * International trade - an overview----... Free tradeFree trade In international trade, free trade is an idealized market model, often stated as a political objective, wherein trade of goo... , economic inequalityEconomic inequality Economic inequality refers to disparities in the distribution of economic assets and income.... , and per capita incomePer capita income The per capita income for a group of people may be defined as their total personal income, divided by the total population.... Mathematical economicsMathematical economics The term mathematical economics is employed in two main senses:... , and econometricsEconometrics *Econometrics* literally means 'economic measurement'.... External links (this is a good source of further links to the academic Balassa-Samuelson effect discussion.) , but says that even countries undergoing very rapid traded-goods productivity growth only experience inflationary pressure in the 1-2% range, and that sources of inflation other than Balassa-Samuelson have proven more significant for past Euro converge candidates like GreeceGreece GreeceGreece lies at the juncture of Europe, Asia, and Africa.... . . "results do not show supportive evidence for the Balassa-Samuelson effect in the long run." 's Product Price Differences across Countries (2004) traces the history of the qualitative description given by the Balassa-Samuelson effect back to David RicardoDavid Ricardo David Ricardo , a political economist, is often credited with systematising economics, and was one of the most influential ... . - Cincibuch & Podpiera (2004) studied the RER appreciation to explain why it exceeds the Balassa-Samuelson prediction in the case of bilateral GermanFacts About Germany Germany , officially the Federal Republic of Germany , is a country in central Europe.... -Central EuropeCentral Europe Central Europe is the region lying between the variously and vaguely defined areas of Eastern and Western Europe.... an country trade as the traded goods' productivity gap has declined. They argue that in practise, border barriers mean that tradables appreciate with productivity, and say: "Real appreciation is also observed in tradables and often accounts for the bulk in the overall appreciation". by professor Ronald MacDonald of Strathclyde University and C. Wojcik of the Warsaw School of Economics.