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.
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The Balassa–Samuelson effect depends on inter-country differences in the relative productivity of the tradable and non-tradable sectors.
Entirely tradable 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.
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.
A typical discussion of this argument (e.g. by Paul Krugman) would include the following features:
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:
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.
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)[2] 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 variables1.
Most professional economists accept that the Balassa–Samuelson effect model has some merit. However other sources of the Penn effect RER/GDP relationship have been proposed:
In a 2001 International Monetary Fund 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".
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).
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.[3] 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.[4]
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.
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.
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 tariffs 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[5]
The supply-side economists (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.)
The Balassa–Samuelson effect model was developed independently in 1964 by Béla Balassa 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.)
(this is a good source of further links to the academic Balassa–Samuelson effect discussion.)