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TheBalassa–Samuelson effect, also known asHarrod–Balassa–Samuelson effect (Kravis and Lipsey 1983), theRicardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect (Samuelson 1994, p. 201), or productivity biasedpurchasing power parity (PPP) (Officer 1976) is the tendency forconsumer prices to be systematically higher in moredeveloped countries than inless developed countries. This observation about the systematic differences in consumer prices is called the "Penn effect". TheBalassa–Samuelson hypothesis is the proposition that this can be explained by the greater variation inproductivity between developed and less developed countries in the traded goods' sectors which in turn affects wages and prices in the non-tradable goods sectors.

Béla Balassa andPaul Samuelson independently proposed the causal mechanism for the Penn effect in the early 1960s.

The Balassa–Samuelson effect depends on inter-country differences in the relativeproductivity of the tradable and non-tradable sectors.

By thelaw of one price, entirelytradable goods cannot vary greatly in price by location because buyers cansource from the lowest cost location. However, mostservices must be delivered locally (e.g.hairdressing), and many manufactured goods such as furniture have high transportation costs or, conversely, low value-to-weight or low value-to-bulk ratios, which makes deviations from the law of one price, known aspurchasing power parity or PPP-deviations, persistent. 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 (in terms of goods produced) of labor, in the nontradable sector is equal between countries and normalized to one.

${\displaystyle MP{L}_{nt,1}=MP{L}_{nt,2}=1}$

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, to produce the Penn effect. What is needed is that wages are at least related to productivity.)

${\displaystyle w_1=p_{nt,1}\ast MP{L}_{nt,1}=p_t\ast MP{L}_{t,1}}$

${\displaystyle w_2=p_{nt,2}\ast MP{L}_{nt,2}=p_t\ast MP{L}_{t,2}}$

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 would include the following features:

• Workers in some countries have higherproductivity 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 skilledZürich burger flipper is no more productive than hisMoscow 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 thelabour intensive work would have beenoff-shored.
• Toequalize local wage levels with the (highly productive) Zürich engineers, Zürich fast food employees must be paid more than Moscow fast food employees, even though the burger production rate per employee is an international constant.
• The CPI is made up of:
  • local goods (which in richer countries are more expensive relative to tradables), and
  • tradables, which have the same price everywhere
• The (real)exchange rate is pegged (by thelaw of one price) 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.

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 thesame country. Therefore, theRER-deviation exists independent of what happens to thenominal 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 some complicating factors:

1. Theeconometrics ofpurchasing power parity (PPP) tests are complicated bynominal exchange rate noise. (This noise would be an econometric problem, even assuming that the exchange rate volatility is a pureerror term).
2. There may be some real economy border effects between countries which limit the flow of tradables or people.
3. Monetary effects, and exchange rate movements^{[note 1]} can affect the real economy and complicate the picture, a problem eliminated if comparing regions that use the samecurrency unit.
4. Taxes are very different in many countries, whereas in a same country taxes are usually equal or similar.

A pint ofpub beer is famously more expensive in the south ofEngland than the north, but supermarketbeer prices are very similar. This may be treated asanecdotal 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 price differentials is that the 'productivity' of pub employees (in pints served per hour) is more uniform than the 'productivity' (in foreign currency earned per year) of people working in the dominant tradable sector in each region of the country (financial services in the south of England,manufacturing in the north). Although the employees of southern pubs are not significantly more productive than their counterparts in the north, southern pubs must pay wages comparable to those offered by other southern firms in order to keep their staff. This results in southern pubs incurring a higher labour cost per pint served.

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 theFour Asian Tigers); conventionaleconometric tests yield mixed findings for this prediction.

In total, since it was (re)discovered in 1964, according to Tica and Druzic (2006)^[1] 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". Many papers have been published since then. Bahmani-Oskooee and Abm (2005) & 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 withendogenoustradability have provided direction for future researchers.

The sector approach combined with panel data analysis and/orcointegration has become a benchmark for empirical tests. Consensus has been reached on the testing of internal and external HBS effects (vis a vis anumeraire country) with a strong reservation against thepurchasing power parity assumption in the tradable sector.

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 confirm the model, while panel data results confirm the model for the majority of countries included in the tests. Although some negative results have been returned, there has been strong support for the predictions of acointegration between relative productivity and relative prices within a country and between countries, while the interpretation of evidence for cointegration between real exchange rate and relative productivity has been much more controversial.

Therefore, most of the contemporary authors (e.g.: Egert, Halpern and McDonald (2006); Drine & Rault (2002)) analyze main BS assumptions separately:

1. The differential of productivities between the traded and non-traded sector and relative prices are positively correlated.
2. Thepurchasing power parity assumption is verified for tradable goods.
3. The RER and relative prices of non-tradable goods are positively correlated.
4. 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 theInternational economics 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 thePenn effect, but there are significanteconometric problems with testing the BS-hypothesis, and the lack of strong evidence for it between modern economies may not refute it, or even 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 affect productivity; if this is true then regressing RER movements on differential productivity growth will be 'polluted' by a totally different relationship between thevariables¹.

Most professional economists accept that theBalassa–Samuelson effect model has some merit. However other sources of thePenn effect RER/GDP relationship have been proposed:

In a 2001International 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.

The Bhagwati–Kravis–Lipsey view provides a somewhat different explanation from the Balassa–Samuelson theory. This view states that price levels for nontradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity. Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Nontradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for nontradables, nontradables are cheaper in poor countries. Wages are high in rich countries, so nontradables are relatively more expensive.^[2]

Capital inflows (say to theNetherlands) may stimulatecurrency appreciation through demand formoney. 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 andHans Falck have studied the effect ofCape Verde remittances on the traded-goods sector.^[3] They find that, as local incomes have risen with a doubling ofremittances from abroad, the Cape VerdeRER 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.^{[note 2]}

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 besuperior goods, which are consumed proportionately more heavily at higher incomes.

A shift in preferences at themicroeconomic level, caused by anincome effect can change the make-up of the consumerprice index to include proportionately more expenditure onservices. This alone may shift theconsumer price index, and might make the non-traded 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, thePenn 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 tofree trade and the domesticprice level. If wealthy countries feel more able to protect their native producers thandeveloping nations (e.g. withtariffs on agricultural imports) we should expect to see a correlation between risingGDP 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 thecommodity 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^{[note 3]}

Thesupply-side economists (and others) have argued that raising international competitiveness through policies that promotetraded goods sectors' productivity (at the expense of other sectors) will increase a nation'sGDP, and increase itsstandard of living, when compared with treating the sectors equally.^{[citation needed]} The Balassa–Samuelson effect might be one reason to oppose thistrade theory, because it predicts that:a GDP gain intraded 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 byBéla Balassa andPaul Samuelson. The effect had previously been hypothesized in the first edition ofRoy Forbes Harrod'sInternational Economics (1939, pp. 71–77), but this portion was not included in subsequent editions.

Partly becauseempirical findings have been mixed, and partly to differentiate the model from its conclusion, modern papers tend to refer to the Balassa–Samuelsonhypothesis, rather than the Balassa–Samuelsoneffect. (See for instance: "A panel data analysis of the Balassa-Samuelson hypothesis", referred to above.)

• List of international trade topics
• Free trade,economic inequality, andper capita income
• Mathematical economics, andeconometrics

• Widely cited examination of the relationship between distribution-sector productivity and the effect with links to the academic Balassa–Samuelson effect discussion
• The European Central Bank defines BS-effect from the inflation point of view but says even countries undergoing very rapid traded-goods productivity growth only experience inflationary pressure in the 1-2% range, and inflation sources other than Balassa–Samuelson have proven more significant for past Euro converge candidates likeGreece.
• An Empirical test of Balassa–Samuelson from 2000.

"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 toDavid Ricardo.
• Paper disputes the applicability of thelaw 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 bilateralGerman-Central European 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 professorRonald MacDonald ofStrathclyde University and C. Wojcik of the Warsaw School of Economics.

• Economics effects

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