DEFINITION of 'Balassa-Samuelson Effect'

Countries with high productivity growth also experience high wage growth, which leads to higher real exchange rates. The Balassa-Samuelson effect suggests that an increase in wages in the tradable goods sector of an emerging economy will also lead to higher wages in the non-tradable (service) sector of the economy. The accompanying increase in inflation makes inflation rates higher in faster growing economies than it is in slow growing, developed economies.

The effect was proposed by economists Bela Balassa and Paul Samuelson in 1963.

BREAKING DOWN 'Balassa-Samuelson Effect'

The Balassa-Samuelson effect suggests that the optimal inflation rate for developing economies is higher than it is for developed countries. Developing economies grow by becoming more productive and using land, labor and capital more efficiently. This results in wage growth in both the tradable good and non-tradable good components of an economy. People consume more goods and services as their wages increase, which in turn pushes up prices.

As emerging economies develop and become more productive they also see increased wages, but they see these increases in both tradable and non-tradable goods sectors of the economy. When wages increase at a slower rate than productivity, countries wind up producing more than they can consume. These countries then have a current-account surplus. When wages grow faster than the productivity rate, workers consumer more goods and the current-account surplus falls.

The effect an appreciating real exchange rate has on an emerging economy depends on whether the country has a fixed exchange rate or floating exchange rate. Fixed exchange rate economies will see an increase in overall prices, while floating exchange rates will see increases in the exchange rate.

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