Balassa-Samuelson effect

The Balassa-Samuelson effect explains how a country could become more expensive over time without losing its international competitiveness.

Consider two countries: an industrialized economy and an emerging market economy. Each of these countries has two sectors: 1) a “tradables” sector producing products that are in direct competition with international producers and 2) a “non-trabables” sector producing only for domestic consumption without international competition.

Let’s say the tradables sector makes cars and the non-tradables sector is construction.

The car companies are exposed to foreign competition and have to raise their efficiency to stay competitive. As a result, they become more profitable and pay higher wages. That attracts employees away from construction and drives them to seek employment in the car industry.

To keep their employees, construction firms have to raise wages as well. The increase in wages is passed on to the prices at the retail level. As a result, the general level of prices increases and we have inflation.

At the end we have a higher inflation rate in the country but competitiveness has not been reduced. The export-oriented firms pay higher wages but they are also more productive.

One example of the Balassa-Samuelson effect is the increase in prices and wages in the former communist countries after they embarked on the transition to capitalism. As these economies modernized and became more competitive, their prices started to catch up with the prices in Western Europe. At the same time, their exports to Western Europe also increased because the firms in Eastern Europe became more efficient and competitive.


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