The Balassa-Samuelson effect was said to be developed independently in the year 1964 by Bela Balassa and Paul Samuelson. The effect is already explained to have been hypothesized in the first edition data of Roy Forbes Harrod’s International Economics, but this same part of the effect was not included in subsequent editions that came up after that. The reason being is that all the empirical findings had been mixed up then; and also because he wanted to differentiate the model from its conclusions.
The Balassa–Samuelson effect can also be called as the ‘Harrod Balassa Samuelson effect’ or ‘Productivity biased Purchasing Power Parity’ (PPP). This effect is the tendency for consumer prices to automatically be higher in more developed countries and lesser in less developed countries. This observation about the systematic differences in available consumer prices is called the ‘Penn effect’. The Balassa–Samuelson effect is something that can be clearly explained by the greater variation in the amount of productivity between developed countries and the less developed countries. This effect can be more correctly pronounced to be regarded in the traded goods sectors than in the non-trade-able sectors.
Bela Balassa and Paul Samuelson both independently proposed the mechanism that was responsible for the Penn effect in the early 1960s. This effect could better be studied by looking at some of the profound features, for example, consider the workers in some countries might have higher productivity than in other countries. This is the ultimate cause and could be a source of income differentiation in the developed and developing countries. This may also be expressed as productivity growth. Certain jobs that are labor-intensive are less responsive to new innovations taking place in productivity than other jobs. The fixed productivity sectors are the ones that are producing some non-transportable goods like just a barber who do haircuts.
To make local wage levels of every sector equal with regards to the high productivity and high income, the workers in that particular sector must get the wages higher as compared to the same level of job that a person does in another country. It is very much possible that two different countries having a job with the same level of hard work and intensity offers the same time of work but different profits from their work. This ultimately results in the workers getting more profits for the same work in one country as compared to the same work in another country.
This could be a possible case when we compare a developed country to a developing country and underdeveloped country. A factor that also affects this disparity in the productivity wastage of two different countries is the money exchange rates. The money exchange rates may vary from country to country. When productivity accounts for income, the real income varies less as compared to the money income.
Thus, we can say that the money exchange rate reflects the real income, or we can say where that the level of price is higher that area is more productive, richer, and has better economies. The proofs for the Penn effect are well known in today’s world and this can be seen better in reality when we travel internationally. The Balassa Samuelson hypothesis states that the countries that have rapidly expanding economies should tend to have more rapidly increasing exchange rates.
MODERN DAY EVOLUTION
With the span of time, the testing of the Balassa-Samuelson model has evolved quite dramatically. New data techniques and this long-time span have crossed all old tests and trade terms have emerged out to be an explanatory variable with new economic methodologies. With the recent improvements in this field, trade has increased and it has also provided good direction to future researchers in a positive manner. The sector approach now has been successfully combined with larger data analysis and the integration of it has become more important for empirical tests.
If we take the analysis of any empirical data, then we come to know that there is a vast majority of the evidence that is in the support of the Balassa-Samuelson model. Also, the deeper analysis of this empirical evidence further shows that the strength of the results is influenced greatly by the nature of the tests and the set of countries that were analyzed for this data. Almost all the cross-sectional tests confirm the Balassa-Samuelson model. According to this Balassa-Samuelson effect, there is always a difference in country-wise productivity. This difference is due to the fact that productivity growth differentials as seen between the trade-able and the non-trade-able sectors is different in different countries.
As understood that high-income generation countries are more technologically and globally advanced, and thus are said to be more productive, when compared to the low-income level countries. It can also be inferred that the advantage of high-income countries is greater in an account for the trade-able goods than for the non-trade-able goods. According to the law of one price, all the prices of all the trade-able goods should be the same across different countries, but not in the case of non-trade-able goods. Higher productivity in case of the trade-able goods means a higher wage for workers in that same sector. This will lead to higher prices and higher wages in local non-trade-able goods that the workers purchase. Therefore, if we consider the productivity difference in the long run between high and low-income countries, it will lead to a trend change between the exchange rates.