The Balassa-Samuelson Effect explains why price levels tend to be higher in richer countries and why rapidly developing economies may experience real exchange-rate appreciation as their productivity rises.
It was independently developed by economists Béla Balassa and Paul Samuelson in 1964.
Basic Mechanism
The economy can broadly be divided into:
- Tradable sector: goods exposed to international competition, such as manufacturing.
- Non-tradable sector: locally consumed services such as housing, haircuts, restaurants and many personal services.
Economic development generally produces faster productivity growth in the tradable sector than in the non-tradable sector.
Higher productivity → higher wages in tradable industries → workers in non-tradable sectors also demand higher wages → wages rise across the economy → non-tradable services become more expensive → overall domestic price level rises.
Thus:
Higher tradable-sector productivity → Higher economy-wide wages → Higher prices of non-tradables → Higher overall price level → Real exchange-rate appreciation
Why Do Wages Rise in Both Sectors?
Suppose manufacturing productivity increases sharply. Manufacturing firms can pay higher wages because each worker produces more output.
However, labour can move between sectors. Restaurants, construction firms and other service providers must therefore also raise wages to retain workers, even if their own productivity has not increased equally.
Since these sectors cannot fully offset higher wages through productivity gains, they increase their prices.
This explains why many labour-intensive services are considerably more expensive in high-income economies.
Impact on the Real Exchange Rate
The real exchange rate reflects the relative price of domestic goods and services compared with foreign goods and services.
As productivity and incomes rise, domestic non-tradable prices increase. Consequently, the country’s real exchange rate appreciates, even if its nominal exchange rate does not appreciate proportionately.
Therefore, a developing economy experiencing rapid productivity growth may simultaneously experience:
- rising wages;
- higher service-sector prices;
- a higher domestic price level; and
- real exchange-rate appreciation.
Purchasing Power Parity
The effect also helps explain why Purchasing Power Parity (PPP) does not hold perfectly across countries.
Tradable goods face international competition, so their prices tend to converge more closely across countries. Non-tradable services cannot be imported easily and therefore show much larger price differences.
Hence, poorer economies generally have lower price levels, particularly for services, while richer economies have higher price levels.
This is also why income differences between rich and developing countries generally appear smaller when GDP is measured at PPP rather than at market exchange rates.
Relevance for Developing Economies
For a rapidly growing economy such as India, productivity improvements in manufacturing and other tradable activities can raise economy-wide wages and gradually increase the relative price of domestic services.
Therefore, some real appreciation accompanying economic convergence can arise from productivity growth rather than simply from monetary expansion or loss of external competitiveness.
