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The Balassa Samuelson Model: How Labour Productivity Can Explain Inflation Differentials

Developed by economists Bela Balassa and Paul Samuelson, the Balassa Samuelson model outlines labour productivity differences between countries; predominantly in the traded goods sector. The model suggests that high income countries are more advanced and thus more productive than low income countries.


The model is a more appropriate model to be used in the long run as short run prices can be sticky. The ‘law of one price’ states that tradable goods should be equal across borders but not for non-tradable goods. However, the higher productivity for the tradable goods sector will result in a higher real wage for workers which will drive the prices of non-tradable goods and services higher (otherwise known as domestic goods and services ie; haircuts, dining etc) which is why the long run differences in productivity will deviate from PPP.

MATHEMATICAL EXAMPLE:

Suppose inflation rates in Ireland was estimated 4.5% higher than the average 2.5% in the Eurozone - and during the same period, Irelands annual real GDP was also 7.5%. Eliminating the scenario of overly expansionary fiscal measures causing higher growth, the Balassa-Samuelson effect could explain the inflationary differentials. Irelands productivity growth were 8% and 2% in the traded & non traded goods sectors respectively. As Ireland's traded good sector is growing much faster than the rest of the Eurozone. Suppose the expenditure share of the non traded goods in the consumption basket is 40%, we can derive the following equation:

So, we can conclude that using the Balassa Samuelson model we can expect the inflation differential between Ireland and the Eurozone to be 2.4% .However, as we can see from this example, the actual differential is only 2% therefore the model suggests that inflation should be up to 0.4% higher.

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