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The theory
Summary of the empirical "Penn Effect" effect to be explainedThe exchange of tradable goods and services should lead prices to converge, but convergence is only partial, because some products are not tradable. (Software development is an example of tradable service.) The interesting Penn effect is that the RER deviations usually occur in the same direction: where incomes are high, prices are relatively expensive compared to an international average, and where they are low, the Consumer Price Index tends to be below the average. Basic form of the effectIf productivity gains against foreign countries are concentrated in the tradable sector, the domestic relative price of non-tradables will increase, and as the relative average price rises, the real money supply contracts, and the Real Exchange Rate (RER) appreciates. If typical productivity gains are concentrated in tradables, high productivity will ultimately be correlated with high RER.
Since traded goods' relative prices are constant (at PPP), but non-traded goods' relative prices are higher, the CPI rises with average productivity growth. The effect in more detailA typical discussion of this argument (e.g. by Paul Krugman) would include the following features:
Equivalent 'Balassa-Samuelson effect' within a countryThe average asking price for a house in a prosperous city can be ten times that of an identical house in a depressed area of the same country. Therefore, the RER-deviation exists independent of a nominal exchange rate cause. Looking at the price level distribution within a country gives a clearer picture of the effect, because this removes three complicating factors:
A pint of pub beer is famously more expensive in the south of England than the North, but supermarket beer prices are very similar. This may be treated as anecdotal evidence in favour of the Balassa-Samuelson hypothesis, since supermarket beer is an easily transportable, traded good. (Although pub beer is transportable, the pub itself is not.) The BS-hypothesis explanation for the varying price differentials is that publican's 'productivity' in serving customers is more uniform (in pints per hour) than is the 'productivity' (in foreign earnings per year) of people working in the export sector in either half of the country. (Reputedly Financial services in the South of England, heavy industry in the North.) The implication that one region is less 'productive' than another is politically controversial. Empirical evidence on the Balassa-Samuelson effect hypothesisEvidence for the Penn effect is well established in the modern era (and is readily observable when traveling internationally). However, econometric evidence that the BS-effect is the mechanism causing the CPI differentials is much less easy to obtain. Kravis & Lipsey's (1991) review of the International Comparison Program has provided evidence that non-traded goods prices do tend to rise faster than (or relative to) traded goods prices. However, the Balassa-Samuelson (BS) hypothesis implies that countries with rapidly expanding economies should tend to have more rapidly appreciating exchange rates (for instance the Four Asian Tigers); conventional time series cointegration tests tend to be unable to reject the null hypothesis that there is no such link. Direct tests of the connection between real exchange rates (RER)s and relative productivities are difficult to perform because of the relatively short time window for which modern-quality econometric data is available. However, these tests have been attempted, again with mixed findings for the predictions of the BS effect. Although some negative results were returned, there has been some support for the predictions of the BS-hypothesis in the literature, for instance:
Drine & Rault (2002) argue that the difficulties of confirming the hypothesis have partly been due to testing particular components of it, and that even where the varying-productivity-RER link is established it doesn't necessarily confirm the BS-hypothesis; they analyzed its main assumptions separately:
For the six Asian economies they followed from 1983 to 1997 they find that although the RER-productivity relationship (4) appears to hold in cointegrating time-series regressions, it cannot be explained by the BS hypothesis, because the evidence rejects assumptions (2) and (3) which are the channels through which the BS-effect supposedly operates. In fact, Drine & Rault's Panel methodology revisions "indicate the absence of a significant co-integrating relationship between real exchange rate and productivity differential", in these data sets. Refinements to the econometric techniques and debate about alternative models are continuing in the International economics community. For instance:
The next section lists some of the alternative proposals to an explanation of the Penn effect, but there are significant econometric problems with testing the BS-hypothesis, and the lack of strong evidence for it between modern economies may not refute it, or imply that it produces a small effect. For instance, other effects of exchange rate movements might mask the long-term BS-hypothesis mechanism (making it harder to detect if it exists). Exchange rate movements are believed by some to have an impact on productivity; if this is true then regressing RER movements on differential productivity growth will be 'polluted' by a totally different relationship between the variables1. Alternative, and additional causes of the Penn effectMost professional economists accept that the Balassa-Samuelson effect model has some merit. However other sources of the RER/GDP relationship have been proposed: The distribution sectorIn a 2001 IMF working paper Macdonald & Ricci accept that relative productivity changes produce PPP-deviations, but argue that this is not confined to tradables versus non-tradable sectors. Quoting the abstract: "an increase in the productivity and competitiveness of the distribution sector with respect to foreign countries leads to an appreciation of the real exchange rate, similarly to what a relative increase in the domestic productivity of tradables does". The Dutch DiseaseCapital inflows (say to the Netherlands) may stimulate currency appreciation through demand for money. As the RER appreciates, the competitiveness of the traded-goods sectors falls (in terms of the international price of traded goods). In this model, there has been no change in real economy productivities, but money price productivity in traded goods has been exogenously lowered through currency appreciation. Since capital inflow is associated with high-income states (e.g Monaco) this could explain part of the RER/Income correlation. Yves Bourdet and Hans Falck have studied the effect of Cape Verde remittances on the traded-goods sector ([2]). They find that, as local incomes have risen with a doubling of remittances from abroad, the Cape Verde RER has appreciated 14% (during the 1990s). The export sector of the Cape Verde economy suffered a similar fall in productivity during the same period, which was caused entirely by capital flows and not by the BS-effect2. A demand side explanationThe Penn effect PPP-deviation can be derived from the demand side of the economy, rather than the Balassa-Samuelson supply side model, in a similar way to the Dutch Disease explanation above. When any non-tradable comes up for sale, its price will be determined by the relative preference between it and money by the average market consumer. By definition, high income consumers have more money, and are indifferent at a higher sale prices between buying an item and not doing so, relative to consumers in a low income area. In tradable goods, supply could shift from poor regions to rich to take advantage of this, forcing price convergence. However, non-tradable supply cannot do this, by definition. Therefore, price differences are caused (in this model) by nothing but relative differences in the abundance of money. In this demand-side model, the initial sources of income difference are treated as given. (Income is either exogenous or evolves based on the ability to sell non-tradables at higher prices where incomes are higher.) This model leads to random walk RER behaviour, as the exogenous rich trickle their wealth down to nearby workers without requiring them to improve productivity (the rich simply bid up local service prices). Charging what the market will bear creates the PPP-deviation in a similar way to the Balassa-Samuelson effect, but doesn't explicitly rely on productivity differentials or the changes in them. Services are a 'superior good'Rudi Dornbusch (1998) and others say that income rises can change the ratio of demand for goods and services (tradable and non-tradable sectors). This is because services tend to be superior goods, which are consumed proportionately more heavily at higher incomes. A shift in preferences at the microeconomic level, caused by an income effect can change the make-up of the consumer price index to include proportionately more expenditure on services. This alone may shift the CPI, and might make the non-trade sector look relatively less productive than it had been when demand was lower; if service quality (rather than quantity) follows diminishing returns to labour input, a general demand for a higher service quality automatically produces a reduction in per-capita productivity. A typical labour market pattern is that high-GDP countries have a higher ratio of service-sector to traded-goods-sector employment than low-GDP countries. If the traded/non-traded consumption ratio is also correlated with the price level the Penn effect would still be observed with labour productivity rising equally fast (in identical technologies) between countries. The protectionism explanationLipsey and Swedenborg (1996) show a strong correlation between the barriers to Free trade and the domestic price level. If wealthy countries feel more able to protect their native producers than developing nations (e.g. with tarrifs on agricultural imports) we should expect to see a correlation between rising GDP and rising prices (for goods in protected industries - especially food). This explanation is similar to the BS-effect, since an industry needing protection must be measurably less productive in the world market of the commodity it produces. However, this reasoning is slightly different from the pure BS-hypothesis, because the goods being produced are 'traded-goods', even though protectionist measures mean that they are more expensive on the domestic market than the international market, so they will not be "traded" internationally3. Trade theory implicationsThe supply-side economists (and others) have argued that raising International competitiveness through policies that promote traded goods sectors' productivity (at the expense of other sectors) will increase a nation's GDP, and increase its standard of living, when compared with treating the sectors equally. The Balassa-Samuelson effect might be one reason to oppose this trade theory, because it predicts that: a GDP gain in traded goods does not lead to as much of an improvement in the living standard as an equal GDP increase in the non-traded sector. (This is due to the effect's prediction that the CPI will increase by more in the former case.) HistoryThe Balassa-Samuelson effect model was developed in 1964 by both Bela Balassa & Paul Samuelson, working independently. It is surprising that both of these economists should have completed their models separately & simultaneously (submitting them to different economic journals) because the outlines of the explanation had been described twenty-five years earlier by Roy Forbes Harrod in "International Economics". Partly because empirical findings have been mixed, and partly to differentiate the model from its conclusion, modern papers tend to refer to the "Balassa-Samuelson hypothesis", rather than the "Balassa-Samuelson effect". (See for instance: "A panel data analysis of the Balassa-Samuelson hypothesis", referred to above.) The future of the 'Balassa-Samuelson effect'If productivity growth is declining then it may limit the size of the Balassa-Samuelson effect, as a halving of productivity growth in both tradable and non-tradable sectors would halve the relative productivity growth as well. If the Balassa-Samuelson (BS) hypothesis is largely responsible for the deviation from purchasing power parity it is asked why the effect's principal assumption is true; why are productivity gains faster in tradable than non-tradable sectors? It is generally assumed that the production of tradables can be automated more completely than non-tradables. (Compare car and car-washes.) In economic jargon this is expressed as: tradables manufacture is more capital intensive. However, the degree to which tradables business is capital intensive may be declining; the knowledge economy has seen the rise of tradable services, such as financial products, with headcount as the principal business expense (implying a low marginal product of capital). If the productivity difference is dependent on capital accumulation, the size of the Penn effect may decline with the economic significance of heavy machinery. However, the market in traded goods must always be more competitive than in non-tradables, simply because it is global. In the tradable marketplace all producers of a commodity are in competition with all the other producers of the same item (and similar substitutes). Non tradables must only out-compete the local rivals. If competition drives productivity growth, tradables will always have higher growth than non-tradables, and (if the hypothesis is true) the Penn effect will always be with us. See also
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