Balassa-Samuelson effect
Encyclopedia
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 parity
(PPP) (Officer 1976) and the rule of five eights (David 1972) is either of two related things:
This article deals with point (2): Balassa
and Samuelson
's causal model. For a fuller description of the stylized fact it attempts to explain see: Penn effect
.
of the tradable and non-tradable sectors.
goods cannot vary
greatly in price by location (because buyers can source from the lowest cost
location). But most services must be delivered locally (e.g. hairdressing) which makes PPP-deviations sustainable. The Penn effect is that PPP-deviations usually occur in the same direction: where incomes are high, average price levels
are typically high.
where "nt" denotes the nontradable sector and 1 and 2 indexes the two countries.
In each country, under the assumption of competition in the labor market the wage ends up being equal to the value of the marginal product, or the sector's price times MPL (note that this is not necessary, just sufficient. What is needed is that wages are at least related to productivity.):
Where the subscript "t" denotes the tradables sector. Note that the lack of a country specific subscript on the price of tradables means that tradable goods prices are equalized between the two countries.
Suppose that country 2 is the more productive, and hence, the wealthier one. This means that
which implies that
.
So with a same (world) price for tradable goods, the price of nontradable goods will be lower in the less productive country, resulting in an overall lower price level.
) would include the following features:
A pint of pub beer is famously more expensive in the south of England
than the North, but supermarket beer
prices are very similar. This may be treated as anecdotal evidence
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 price
differentials is that publican
'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 export
sector in either half of the country. (Reputedly Financial services
in the South of England, heavy industry
in the North.) The implication that one region is less 'productive' than another is politically controversial.
In total, since it was (re)discovered in 1964, according to Tica and Druzic (2006) the HBS theory "has been tested 60 times in 98 countries in time series or panel analyses and in 142 countries in cross-country analyses. In these analyzed estimates, country specific HBS coefficients have been estimated 166 times in total, and at least once for 65 different countries". Also, one should have in mind that a lot of papers have been published since then. Bahmani-Oskooee and Abm (2005) and Egert, Halpern and McDonald (2006) also provide quite interesting surveys of empirical evidence on BS effect.
Over time, the testing of the HBS model has evolved quite dramatically. Panel data and time series techniques have crowded out old cross-section tests, demand side and terms of trade variables have emerged as explanatory variables, new econometric methodologies have replaced old ones, and recent improvements with endogenous tradability have provided direction for future researchers.
The sector approach combined with panel data analysis and/or cointegration has become a benchmark for empirical tests. Consensus has been reached on the testing of internal and external HBS effects (vis a vis a numeraire country) with a strong reservation against the purchasing power parity
assumption in the tradable sector.
Analysis of empirical evidence shows that the vast majority of the evidence supports the HBS model. A deeper analysis of the empirical evidence shows that the strength of the results is strongly influenced by the nature of the tests and set of countries analyzed. Almost all cross-section tests confirmed the model, while panel data results confirmed the model for the majority of countries included in the tests. Although some negative results were returned, there has been strong support for the predictions of the cointegration
between relative productivity and relative prices within a country and between countries, while evidence for cointegration
between real exchange rate and relative productivity were much more controversial.
Therefore, most of the contemporary authors (see for example: Egert, Halpern and McDonald (2006) or Drine & Rault (2002) ) analyze main BS assumptions separately:
Refinements to the econometric techniques and debate about alternative models are continuing in the International economics
community. For instance:
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 variables
1.
RER/GDP
relationship have been proposed:
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".
) 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).
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.
Yves Bourdet and Hans Falck have studied the effect of Cape Verde
remittances on the traded-goods sector. 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-effect.
(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.
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 consumer price index
, 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.
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.
and the domestic price level
. If wealthy countries feel more able to protect their native producers than developing nations (e.g. with tariff
s on agricultural imports) we should expect to see a correlation between rising GDP
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 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
" internationally
(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 living
, 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.)
and Paul Samuelson
. The effect had previously been hypothesized in the first edition of Roy Forbes Harrod's International Economics (1939, pp. 71-77), but this portion was not included in subsequent editions.
Partly because empirical
findings have been mixed, and partly to differentiate the model from its conclusion, modern papers tend to refer to the Balassa–Samuelson hypothesis
, rather than the Balassa–Samuelson effect. (See for instance: "A panel data analysis of the Balassa-Samuelson hypothesis", referred to above.)
as well as the productivity—exchange rate
link)...
(this is a good source of further links to the academic Balassa–Samuelson effect discussion.)
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
(PPP) (Officer 1976) and the rule of five eights (David 1972) is either of two related things:
- The observation that consumer priceConsumer price indexA consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
levels in richer countries are systematically higher than in poorer ones (the "Penn effectPenn effectThe Penn effect is the economic finding associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates...
"). - An economic model predicting the above, based on the assumption that productivityProductivityProductivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
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): Balassa
Béla Balassa
Béla Balassa was a Hungarian economist and world-renowned professor at Johns Hopkins University; most famous for his work on the relationship between purchasing power parity and cross-country productivity differences .Balassa received a law degree from the University of Budapest...
and Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
's causal model. For a fuller description of the stylized fact it attempts to explain see: Penn effect
Penn effect
The Penn effect is the economic finding associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates...
.
The theory
The Balassa–Samuelson effect depends on inter-country differences in the relative productivityProductivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
of the tradable and non-tradable sectors.
The empirical "Penn Effect" effect
Entirely tradableTradable
Tradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the cost of transportation and the shorter the shelf life,...
goods cannot vary
Law 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."-Intuition:The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market...
greatly in price by location (because buyers can source from the lowest cost
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
location). But most services must be delivered locally (e.g. hairdressing) which makes PPP-deviations sustainable. The Penn effect is that PPP-deviations usually occur in the same direction: where incomes are high, average price levels
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
are typically high.
Basic form of the effect
The simplest model which generates a Balassa–Samuelson effect has two countries, two goods (one tradable, and a country specific nontradable) and one factor of production, labor. For simplicity assume that productivity, as measured by marginal product of labor, in the nontradable sector is equal between countries and normalized to one.where "nt" denotes the nontradable sector and 1 and 2 indexes the two countries.
In each country, under the assumption of competition in the labor market the wage ends up being equal to the value of the marginal product, or the sector's price times MPL (note that this is not necessary, just sufficient. What is needed is that wages are at least related to productivity.):
Where the subscript "t" denotes the tradables sector. Note that the lack of a country specific subscript on the price of tradables means that tradable goods prices are equalized between the two countries.
Suppose that country 2 is the more productive, and hence, the wealthier one. This means that
which implies that
.So with a same (world) price for tradable goods, the price of nontradable goods will be lower in the less productive country, resulting in an overall lower price level.
The effect in more detail
A typical discussion of this argument (e.g. by Paul KrugmanPaul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
) would include the following features:
- Workers in some countries have higher productivityProductivityProductivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
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 ZurichZürichZurich is the largest city in Switzerland and the capital of the canton of Zurich. It is located in central Switzerland at the northwestern tip of Lake Zurich...
burger flipper is no more productive than his MoscowMoscowMoscow is the capital, the most populous city, and the most populous federal subject of Russia. The city is a major political, economic, cultural, scientific, religious, financial, educational, and transportation centre of Russia and the continent...
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-shoredOffshoringOffshoring describes the relocation by a company of a business process from one country to another—typically an operational process, such as manufacturing, or supporting processes, such as accounting. Even state governments employ offshoring...
. - 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 rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
is pegged (by the law of one priceLaw of one priceThe law of one price is an economic law stated as: "In an efficient market, all identical goods must have only one price."-Intuition:The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market...
) so that tradable goods follow PPP (purchasing power parity). 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 econometricsEconometricsEconometrics has been defined as "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations." More precisely, it is "the quantitative analysis of actual economic phenomena based on...
of purchasing power parityPurchasing power parityIn economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
(PPP) tests are complicated by nominal exchange rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
noise. (This noise would be an econometric problem, even assuming that the exchange rate volatility is a pure error termStandard error (statistics)The standard error is the standard deviation of the sampling distribution of a statistic. The term may also be used to refer to an estimate of that standard deviation, derived from a particular sample used to compute the estimate....
). - 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 currencyCurrencyIn economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
unit.
A pint of pub beer is famously more expensive in the south of England
England
England is a country that is part of the United Kingdom. It shares land borders with Scotland to the north and Wales to the west; the Irish Sea is to the north west, the Celtic Sea to the south west, with the North Sea to the east and the English Channel to the south separating it from continental...
than the North, but supermarket beer
Beer
Beer is the world's most widely consumed andprobably oldest alcoholic beverage; it is the third most popular drink overall, after water and tea. It is produced by the brewing and fermentation of sugars, mainly derived from malted cereal grains, most commonly malted barley and malted wheat...
prices are very similar. This may be treated as anecdotal evidence
Anecdotal evidence
The expression anecdotal evidence refers to evidence from anecdotes. Because of the small sample, there is a larger chance that it may be true but unreliable due to cherry-picked or otherwise unrepresentative of typical cases....
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 price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
differentials is that publican
Public house
A public house, informally known as a pub, is a drinking establishment fundamental to the culture of Britain, Ireland, Australia and New Zealand. There are approximately 53,500 public houses in the United Kingdom. This number has been declining every year, so that nearly half of the smaller...
'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 export
Export
The term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer"...
sector in either half of the country. (Reputedly Financial services
Financial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are credit unions, banks, credit card companies, insurance companies, consumer finance companies,...
in the South of England, heavy industry
Industry
Industry refers to the production of an economic good or service within an economy.-Industrial sectors:There are four key industrial economic sectors: the primary sector, largely raw material extraction industries such as mining and farming; the secondary sector, involving refining, construction,...
in the North.) The implication that one region is less 'productive' than another is politically controversial.
Empirical evidence on the Balassa–Samuelson effect hypothesis
Evidence for the Penn effect is well established in today's world (and is readily observable when traveling internationally). 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 Four Asian Tigers); conventional econometric tests have resulted with mixed findings for the predictions of the BS effect.In total, since it was (re)discovered in 1964, according to Tica and Druzic (2006) the HBS theory "has been tested 60 times in 98 countries in time series or panel analyses and in 142 countries in cross-country analyses. In these analyzed estimates, country specific HBS coefficients have been estimated 166 times in total, and at least once for 65 different countries". Also, one should have in mind that a lot of papers have been published since then. Bahmani-Oskooee and Abm (2005) and Egert, Halpern and McDonald (2006) also provide quite interesting surveys of empirical evidence on BS effect.
Over time, the testing of the HBS model has evolved quite dramatically. Panel data and time series techniques have crowded out old cross-section tests, demand side and terms of trade variables have emerged as explanatory variables, new econometric methodologies have replaced old ones, and recent improvements with endogenous tradability have provided direction for future researchers.
The sector approach combined with panel data analysis and/or cointegration has become a benchmark for empirical tests. Consensus has been reached on the testing of internal and external HBS effects (vis a vis a numeraire country) with a strong reservation against the purchasing power parity
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
assumption in the tradable sector.
Analysis of empirical evidence shows that the vast majority of the evidence supports the HBS model. A deeper analysis of the empirical evidence shows that the strength of the results is strongly influenced by the nature of the tests and set of countries analyzed. Almost all cross-section tests confirmed the model, while panel data results confirmed the model for the majority of countries included in the tests. Although some negative results were returned, there has been strong support for the predictions of the cointegration
Cointegration
Cointegration is a statistical property of time series variables. Two or more time series are cointegrated if they share a common stochastic drift.-Introduction:...
between relative productivity and relative prices within a country and between countries, while evidence for cointegration
Cointegration
Cointegration is a statistical property of time series variables. Two or more time series are cointegrated if they share a common stochastic drift.-Introduction:...
between real exchange rate and relative productivity were much more controversial.
Therefore, most of the contemporary authors (see for example: Egert, Halpern and McDonald (2006) or Drine & Rault (2002) ) analyze main BS assumptions separately:
- The differential of productivities between traded and non-traded sector and relative prices are positively correlated.
- The purchasing power parityPurchasing power parityIn economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
assumption is verified for tradable goods. - The RER and relative prices of non-tradable goods are positively correlated.
- As a consequence of 1, 2, & 3, there is a long-run relationship between productivity differentials and the RER.
Refinements to the econometric techniques and debate about alternative models are continuing in the International economics
International economics
International economics is concerned with the effects upon economic activity of international differences in productive resources and consumer preferences and the institutions that affect them...
community. For instance:
- "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.
The next section lists some of the alternative proposals to an explanation of the Penn effect
Penn effect
The Penn effect is the economic finding associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates...
, 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 variables
Variable (mathematics)
In mathematics, a variable is a value that may change within the scope of a given problem or set of operations. In contrast, a constant is a value that remains unchanged, though often unknown or undetermined. The concepts of constants and variables are fundamental to many areas of mathematics and...
1.
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 associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates...
RER/GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
relationship have been proposed:
The distribution sector
In a 2001 International Monetary FundInternational Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
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 a constituent country of the Kingdom of the Netherlands, located mainly in North-West Europe and with several islands in the Caribbean. Mainland Netherlands borders the North Sea to the north and west, Belgium to the south, and Germany to the east, and shares maritime borders...
) may stimulate currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
appreciation through demand for money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
. 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. Monaco
Monaco
Monaco , officially the Principality of Monaco , is a sovereign city state on the French Riviera. It is bordered on three sides by its neighbour, France, and its centre is about from Italy. Its area is with a population of 35,986 as of 2011 and is the most densely populated country in the...
) this could explain part of the RER/Income correlation.
Yves Bourdet and Hans Falck have studied the effect of Cape Verde
Cape Verde
The Republic of Cape Verde is an island country, spanning an archipelago of 10 islands located in the central Atlantic Ocean, 570 kilometres off the coast of Western Africa...
remittances on the traded-goods sector. They find that, as local incomes have risen with a doubling of remittances from abroad, the Cape Verde RER
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
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.
Services are a 'superior good'
Rudi DornbuschRudi Dornbusch
Rüdiger "Rudi" Dornbusch was a German economist who worked for most of his career in the United States.-Biography:...
(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.
A shift in preferences at the microeconomic
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...
level, caused by an income effect
Income effect
In economics, the consumer's preferences, money income and prices play an important role in solving the consumer's optimization problem...
can change the make-up of the consumer price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...
to include proportionately more expenditure on services. This alone may shift the consumer price index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
, 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.
A typical labour market pattern is that high-GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
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
Penn effect
The Penn effect is the economic finding associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates...
would still be observed with labour productivity rising equally fast (in identical technologies) between countries.
The protectionism explanation
Lipsey and Swedenborg (1996) show a strong correlation between the barriers to Free tradeFree trade
Under a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...
and the domestic price level
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
. If wealthy countries feel more able to protect their native producers than developing nations (e.g. with tariff
Tariff
A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....
s on agricultural imports) we should expect to see a correlation between rising GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
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 commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
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
Export
The term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer"...
" internationally
Trade theory implications
The supply-side economistsSupply-side economics
Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively created by lowering barriers for people to produce goods and services, such as lowering income tax and capital gains tax rates, and by allowing greater flexibility by reducing...
(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 living
Standard of living
Standard of living is generally measured by standards such as real income per person and poverty rate. Other measures such as access and quality of health care, income growth inequality and educational standards are also used. Examples are access to certain goods , or measures of health such as...
, 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 independently in 1964 by Béla BalassaBéla Balassa
Béla Balassa was a Hungarian economist and world-renowned professor at Johns Hopkins University; most famous for his work on the relationship between purchasing power parity and cross-country productivity differences .Balassa received a law degree from the University of Budapest...
and Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
. The effect had previously been hypothesized in the first edition of Roy Forbes Harrod's International Economics (1939, pp. 71-77), but this portion was not included in subsequent editions.
Partly because empirical
Empirical
The word empirical denotes information gained by means of observation or experimentation. Empirical data are data produced by an experiment or observation....
findings have been mixed, and partly to differentiate the model from its conclusion, modern papers tend to refer to the Balassa–Samuelson hypothesis
Hypothesis
A hypothesis is a proposed explanation for a phenomenon. The term derives from the Greek, ὑποτιθέναι – hypotithenai meaning "to put under" or "to suppose". For a hypothesis to be put forward as a scientific hypothesis, the scientific method requires that one can test it...
, rather than the Balassa–Samuelson effect. (See for instance: "A panel data analysis of the Balassa-Samuelson hypothesis", referred to above.)
See also
- List of international trade topics
- Free tradeFree tradeUnder a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...
, economic inequalityEconomic inequalityEconomic inequality comprises all disparities in the distribution of economic assets and income. The term typically refers to inequality among individuals and groups within a society, but can also refer to inequality among countries. The issue of economic inequality is related to the ideas of...
, and per capita incomePer capita incomePer capita income or income per person is a measure of mean income within an economic aggregate, such as a country or city. It is calculated by taking a measure of all sources of income in the aggregate and dividing it by the total population... - Mathematical economicsMathematical economicsMathematical economics is the application of mathematical methods to represent economic theories and analyze problems posed in economics. It allows formulation and derivation of key relationships in a theory with clarity, generality, rigor, and simplicity...
, and econometricsEconometricsEconometrics has been defined as "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations." More precisely, it is "the quantitative analysis of actual economic phenomena based on...
Further reading
.............. (Discusses national comparative advantageComparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
as well as the productivity—exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
link)...
External links
(this is a good source of further links to the academic Balassa–Samuelson effect discussion.)
- The European Central Bank defines the BS-effect from the inflation point of view, 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 GreeceGreeceGreece , officially the Hellenic Republic , and historically Hellas or the Republic of Greece in English, is a country in southeastern Europe....
. - An Empirical test of Balassa–Samuelson from 2000.
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- "results do not show supportive evidence for the Balassa–Samuelson effect in the long run."
- Useful summary of the different Exchange Rate Equilibrium models, including Balassa–Samuelson, as models for estimating a stable Koruna/Euro level
- The International Association for Research in Income and Wealth's Product Price Differences across Countries (2004) traces the history of the qualitative description given by the Balassa–Samuelson effect back to David RicardoDavid RicardoDavid Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...
. - Paper disputes the applicability of the law of one price to traded goods; so that the pure Balassa–Samuelson effect is an underestimate of likely RER changes - Cincibuch & Podpiera (2004) studied the RER appreciation to explain why it exceeds the Balassa–Samuelson prediction in the case of bilateral GermanGermanyGermany , officially the Federal Republic of Germany , is a federal parliamentary republic in Europe. The country consists of 16 states while the capital and largest city is Berlin. Germany covers an area of 357,021 km2 and has a largely temperate seasonal climate...
-Central EuropeCentral EuropeCentral Europe or alternatively Middle Europe is a region of the European continent lying between the variously 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".
- A breakdown of the demand and supply side effects on the exchange rate from rising productivity by professor Ronald MacDonald of Strathclyde University and C. Wojcik of the Warsaw School of Economics.
- "results do not show supportive evidence for the Balassa–Samuelson effect in the long run."