Question

The new member states are likely to be affected by the Balassa-Samuelson effect. What does this imply for their inflation rates once they join the Eurozone?

Answer 1

Balassa-Samuelson effect proposes that increase in wage rates in the trade sectors also lead to increase in wage of the non-trade sectors. So, it makes inflation rate to increase as the general price level of the economy increases. For the country joining Eurozone, it implies that the country will have better opportunities for trade and it will cause demand and wage rate of the workers in trade related sectors to increase. With increase in wages of these workers, demand for services or non-trade sector increases and it leads to increase in wage of workers in service sector as well. It also happens as workers move in those sectors where wages are high. It makes service providers to increase wage so that they get good workers. It overall increases the cost of production of goods and services. It leads to increase in price level and inflation increases. This implication with respect to rising inflation is observed when a country joins Eurozone. It is termed as Balassa-Samuelson effect.