Question

According to the Balassa-Samuelson effect, price levels are related to productivity in the tradables sector.

a. Explain the intuition behind the Balassa-Samuelson effect.

b. What does the Balassa-Samuelson effect imply for differences in price levels between rich and poor countries?

c. What does the Balassa-Samuelson effect imply for differences in inflation between rich and poor countries?

Answer 1

a. Balassa-Samuelson effect states that high growth in production of goods lead to high wage rate, which in turn increases the purchasing power of the consumer. This further leads to price inflation and hence increase in inflation rate. Surprisingly, developing countries show more inflation rate as compared to developed countries as developing countries are more tend to become more productive and hence leads to increase in wage rate and inflation rate.

b. Poo countries are in the categories of developing countries and these countries are more focused towards production that leads to growth in production rate.Increased production leads to increase wage rate and further leads to increase in price.On the other hand, rich countries are in the categories of developed countries and their relative growth is not much and hence it does not further leads to price inflation as in case of developing countries.

c. From point B, it is clear that as per Balassa-Samuelson effect, poor countries are more prone to high wage rate as compared to rich and developed countries.High price rate in poor countries, lead to high inflation rate in comparison to rich and developed countries.