This post considers the famous and somewhat contentious issue of Purchasing Power Parity (PPP), and the deviations from it explained by what is known as the Balassa-Samuelson Effect. In doing so it is hoped it will facilitate the understanding of one of the explanations of why inflation is higher in developing countries that are playing economic catch up with developed ones. Finally a concluding remark is made that the inherent implication of this result is that price levels are higher in developed countries than in developing countries.
The International Economy, Real Exchange Rates and PPP
One of the main focuses of international economics is the Real exchange rate relationship, which is often the starting point of derivation for many pertinent issues. The equation states that the real exchange rate “E” is a function of the nominal exchange rate “e” normalised by the inverse ratio of the corresponding Price levels. So that comparing a catching up (i.e.: developing) country “C” with a Developed country “D”, we get the following real exchange rate function:
Simply put, PPP states the law of one price that Δєt =0. If so, this implies that changes in the nominal exchange rate are compensated by adjustments in the rates of inflation to ensure that the real exchange rate is the same in every period, so that
This, it is argued is due to the fact real price arbitrage and competition would drive prices would level prices and nominal exchange rates to bring the real cost of the perennial Big Mac (or of any other good) to a single real value all over the world.
However, this relationship break up between developing and developed countries or to put it in more concrete terms, it traditionally did not hold between the EU15 and the CEE10 accession countries, whose economies were not as integrated as those of the member states (MSs). Indeed, as the table below shows (see same source),prices in the CEE10 experienced substantial inflation during the 12 years between 1996 and 2008, thus decreasing these economies competitiveness.
Indeed, inflation was much too high in the accession countries. The next section consider
Problems with PPP – The Balassa-Samuelson Effect
There are several drivers for these deviations from PPP, including transaction costs, product differentiation, fixed investment thresholds or composition (measurement) issues. In this section I focus on another issue, the one created by the differences between traded and non-traded goods famous as the Balassa-Samuelson effect.
In this model, total inflation is given by the following relationship between inflation in traded and in non-traded goods:
where the subscript “T” stands for “traded goods” and the subscript “N” stands for “non-traded goods”, and α is the proportion of non-traded good in the economy.
This theory argues that PPP only holds for traded goods rather than for all of the economy’s goods. Thus ignoring time periods “t” and considering sectors “T” and “N”, PPP is given as
Thus, as per Buiter, the inflation differential between the two countries will
However, this equation tells us little, given that we have so far made no assumptions or inferences about the behaviour of sectorial inflation. This is possible if we consider the whole economy’s sectorial production function.
To do this, I follow De Grauwe in considering the following Cobb-Douglas economy wide production function for the representative firm:
Now, because the “catching up” country is indeed “catching up”, productivity growth in the tradable sector, where competition is highest, can be assumed to be larger than for the developed country. In that case it must be that the inflation differentials between developing and developed countries are always positive and above the nominal exchange rate, thus challenging PPP.
Inflation and Price levels
The consequence of the above result that PPP will not be confirmed between developing and developed economies, is due to the fact that inflation from the productivity sector will lead to a rise in tradable and thus overall inflation; countries going through a catching up process will always incur higher levels of inflation than their developed brethren.
Interestingly, the implicit conclusion hidden behind this argument is that the price level of developed economies will always be higher than that of developing nations, coetris paribus, because they themselves went through that fact productivity growth period that led to inflation and the inevitably ensuing higher price level. Of course there are exceptions, but this is one of the many reasons why the same good will generally be cheaper in a developing country rather than in a developed one.