PRICE CONVERGENCE (BALASSA-SAMUELSON EFFECT) International Macroeconomics 8 March 2016 Tomáš Holub

Single tradable good (real ER always equal to 1); Purchasing power parity (absolute version) Based on simple arbitrage principle. So far we have assumed:

An increase in relative GDP by 1 p.p.  an increase in relative price level by  p.p. Note the large R2 (around 0.9). GDP in PPP vs. Price Level (European country sample, 2014)

An increase in relative GDP by 1 p.p.  an increase in the price level (relative to the US) by  0.40 p.p. R2 much smaller, but still statistically significant. GDP in PPP vs. Price Level (global country sample, Penn World Table, 2009)

GDP in PPS vs. Price Level of GDP (European Panel, )

GDP in PPS vs. Price Level of Consumption (European Panel, )

Real Appreciation Trend in CEECs Fast real appreciation trend (on HICP-basis) in all CEE countries before the crisis, irrespective of the exchange rate regime; So the PPP holds neither in the cross-country, nor in the time series perspective (and thus nor in its relative version); Partly explained by Balassa-Samuelson (B-S) effect.

B-S with One-Factor P.F.

B-S with Three-Factor P.F.

Basic Convergence Scenario The right-hand chart shows the convergence of a country, which starts with a GDP in PPP at 50 % of the steady state.

So far, we have argued that on the aggregate level, the B-S model works quite well; But it has shortcomings related to:  Inability to fully explain the price convergence in CEECs  Significance of other factors in the cross-country comparisons  Inability to clearly distinguish T and NT goods  Appreciation also on PPI basis, T-o-T improvements Modern literature thus focuses more on convergence in T prices, investment into quality, endogenous tradability of goods, etc. Some Problems with the B-S Effect

Structure of Czech Inflation The „internal B-S effect“ has been apparent in the Czech inflation, even though its strenght has declined (and Flek, et al., 2003; or Égert, et al., 2003 questioned that it was strong enough even in the past to generate an „external B-S effect“); The chart also shows the importance of price deregulations.

Real Convergence – Regional Comparison In CZ and SK, real appreciation by far exceeded the GDP growth differential. The PL case reflects the period since 2007 (ongoing GDP convergence with slight real ER depreciation). SI has been traditionally different (very little convergence).

Extended Regression (Panel) Low coefficients of the B-S factors, significance of other variables.

Commodity Groups‘ Prices and GDP Empirically, hard to indentify clearly tradable commodity groups; Relationship of prices to the GDP level significant for most groups; Could be used as an empirical measure of the „degree of tradability“.

Appreciation on CPI and PPI Basis Appreciation trend of CZK before the crisis was apparent both on the CPI and PPI basis.

Brůha, Podpiera, Polák (2010) Used a calibrated DGE model with: external borrowing; transfer of technology and productivity (FDI); self-selection into the export market; and investment in quality.

Conclusions (i) PPP does not hold in a cross-country and time series comparison (i.e. it holds neither in its absolute nor in the relative version); B-S based on strictly differentiating between T and NT goods; Can be linked with the open economy growth model with human capital accumulation; The B-S model consistent with the cross-country and panel data comparisons at the aggregate level; Benchmark scenario: 1 p.p. real growth differential; real exchange rate appreciation of about 0.8 p.p (But!…).

Conclusions (ii) But some empirical studies question the importance of the B-S effect; Structure of foreign trade and other factors have an important influence on the price level, too (e.g. ToT); Empirically, hard to differentiate T and NT goods; Modern literature thus focuses more on convergence in T prices, investment into quality, endogenous tradability of goods, etc.

References Balassa, B. (1964) The Purchasing Power Parity Doctrine: A Reappraisal, Journal of Political Economy, vol. 72, pp. 584–96. Brůha, J., Podpiera, J. and S. Polák (2010): The Convergence Dynamics of a Transition Economy: The Case of Czech Republic, Economic Modelling, pp ( ). Čihák, M., and T. Holub (2001a) Convergence of Relative Prices and Inflation in the CEE Countries. Washington, D.C.: IMF Working Paper, no. 01/124. Čihák, M., and T. Holub (2005) Price Convergence in EU-Accession Countries: Evidence from the International Comparison, Économie Internationale, 2005 (2e trimester), no. 102, pp. 61–84. Égert, B., I. Drine, K. Lommatzsch and C. Rault (2003) The Balassa–Samuelson effect in Central and Eastern Europe: myth or reality? Journal of Comparative Economics, vol. 31, iss. 3, pp Flek, V., L. Marková, and J. Podpiera (2003) Sectoral Productivity and Real Exchange Rate Appreciation: Much Ado about Nothing? Czech Journal of Economics and Finance, 2003, vol. 53, iss. 3-4, pp Kulhavá, K. and L. Matějková (eds.) Analyses of the Czech Republic's current economic alignment with the euro area Prague, Czech National Bank, Holub, T., and M. Čihák (2003) Price Convergence: What Can the Balassa-Samuelson Model Tell Us? Czech Journal of Economics and Finance, vol. 53, iss. 7-8, pp Komárek, L., K. Koprnická and P. Král (2010) Dlouhodobá reálná apreciace jako fenomén ekonomické konvergence, Politická ekonomie, no. 1. Samuelson, P.A. (1964) Theoretical Notes on Trade Problems, Review of Economics and Statistics, vol. 46 (May), pp. 145–154.