Balassa-Samuelson Effect: Overview of the Economic Theory

What Is the Balassa-Samuelson Effect?

The Balassa-Samuelson effect states that productivity differences between the production of tradable goods in different countries 1) explain large observed differences in wages and in the price of services and between purchasing power parity and currency exchange rates, and 2) it means that the currencies of countries with higher productivity will appear to be undervalued in terms of exchange rates; this gap will increase with higher incomes.?

The Balassa-Samuelson effect suggests that an increase in wages in the tradable goods sector of an emerging economy will also lead to higher wages in the non-tradable (service) sector of the economy. The accompanying increase in prices makes inflation rates higher in faster-growing economies than it is in slow-growing, developed economies.

Understanding the Balassa-Samuelson Effect

The Balassa-Samuelson effect was proposed by economists Bela Balassa and Paul Samuelson in 1964. It identifies productivity differences as the factor that leads to systematic deviations in prices and wages between countries, and between national incomes expressed using exchange rates and purchasing power parity (PPP). These differences had been previously documented by empirical data gathered by researchers at the University of Pennsylvania and are readily observable by travelers between different countries. 

According to the Balassa-Samuelson effect, this is due to productivity growth differentials between the tradable and non-tradable sectors in different countries. High-income countries are more technologically advanced, and thus more productive, than low-income countries, and the advantage of high-income countries is greater for the tradable goods than for the non-tradable goods. According the law of one price, the prices of tradable goods should be equal across countries, but not for non-tradable goods. Higher productivity in tradable goods will mean higher real wages for workers in that sector, which will lead to higher relative price (and wages) in local non-tradable goods that those workers purchase. Therefore, the long-run productivity difference between high- and low-income countries leads to trend deviations between exchange rates and PPP. This also means that countries with lower per capita income will have lower domestic prices for services and lower price levels.

The Balassa-Samuelson effect suggests that the optimal inflation rate for developing economies is higher than it is for developed countries. Developing economies grow by becoming more productive and using land, labor, and capital more efficiently. This results in wage growth in both the tradable good and non-tradable good components of an economy. People consume more goods and services as their wages increase, which in turn pushes up prices. This implies that an emerging economy that is growing by raising its productivity will experience rising price levels. In developed countries, where productivity is already high and not rising as quickly, inflation rates should be lower.