Balassa-Samuelson Effect for Russia

"The Balassa-Samuelson framework (Balassa, 1964 and Samuelson, 1964) gives a theoretical foundation for deviation from the Purchasing Power Parity (PPP) condition, particularly adapted for explaining medium-to-long run exchange rate movements in emerging economies. The model is based on the presence of two sectors in the economy, a tradable sector open to international competition and a non-tradable sector. The central assumption is that the PPP condition holds for the tradable sector, where productivity rises much faster than in the non-tradable sector. The level of productivity in the tradable sector in turn determines the wage level for the whole economy, as labour mobility implies wage equalisation across sectors. The non-tradable sector, facing smaller productivity gains, can accommodate wage increases only by raising prices. This price inflation - the so-called Balassa Samuelson effect – is thus generated by productivity gains in the tradable sector and, in this simplifying model,1 is not detrimental to competitiveness.

This framework also provides a mechanism for understanding the real appreciation of the currency in the catching-up economy. Under the Balassa-Samuelson assumptions, the real exchange rate depends only on the difference between (1) the relative productivity of the domestic tradable sector with respect to the domestic nontradable sector and (2) the relative productivities of the tradable and non-tradable sectors abroad. Given that relative productivity gains in the tradable sector are likely to be higher in emerging economies than in developed ones, catching-up countries are expected to have higher inflation in the non-tradable sector and, consequently, higher inflation in the economy. As the Balassa-Samuelson effect is an equilibrium phenomenon, the underlying real appreciation is sustainable and may thus be considered as a benchmark for the real appreciation path.

Several empirical methods have been used to test or assess the size of this effect, particularly for Central and Eastern European countries. One approach consists in looking at the transmission of the domestic productivity differential between the tradable and non tradable sectors into relative domestic prices (i.e. the “internal transmission mechanism). An alternative and complementary approach explores the link between the dual productivity differential between countries (or the dual relative price differential) and the real exchange rate. Both types of studies usually find an effect on inflation ranging between 1 and 3% (Égert 2003 for a survey, Rosati, 2002, Kovacs, 2002), depending, inter alia, on the definition of the non-tradable sector.

For Russia, Égert (2005) estimates the contribution of the Balassa Samuelson effect to average CPI inflation at 1.1% for 1996-2001. Productivity gains by sector and relative price developments in Russia are reported in Figure 14 (on an annual basis). As expected, productivity gains are much higher in industry, agriculture and construction than in services, and prices increased more rapidly in the non-tradable sector than in the tradable ones. The inflation differential, however, appears to be limited, which would suggest a modest Balassa-Samuelson effect on overall inflation and would tend to confirm the order of magnitude found by Égert."

- A golden rule for Russia? How a rule-based fiscal policy can allow a smooth adjustment to the new terms of trade, p.23-24

Related;
Equilibrium Exchange Rates in Southeastern Europe, Russia, Ukraine and Turkey: Healthy or (Dutch) Diseased?
The Balassa-Samuelson effect in central Europe: a disaggregated analysis

A Few Notes on Trade
The Chronicles of Macroeconomics