w 109 long-run economic aspects of the european union's eastern ...

ANNEXESANNEX 1THE BALASSA-SAMUELSON EFFECTThis annex discusses the likely size of the Balassa-Samuelson effect (B-S effect) forthe candidate countries by using two approaches: the first starts from the theory,whereas the second is purely empirical and based on the Euro area experience.1.1 THEORETICAL CONSIDERATIONS 1In theory, if all goods and services were freely tradable across borders, arbitragewould lead to a situation in which price levels (expressed in common currency)would be equal and strict purchasing power parity would hold. However, this israrely the case in practice, and a number of studies have shown that price levels dodiffer markedly across countries. These differences are so large that they cannot beaccounted for by transport costs, taxes and tariffs. In fact, there is a systematictendency for prices to be lower in poorer than in richer countries and, when examinedmore closely, this pattern seems to be accounted for by differences in theprices of ‘non-traded’ goods and services, e.g. housing and personal services.Moreover, there is a tendency for countries which are experiencing more rapidgrowth of productivity – and, therefore, improvements in living standards – toexperience faster increases in price levels (again, correcting for exchange ratemovements). The Balassa-Samuelson approach (Balassa 1964, Samuelson 1964)explains these differences by linking the behaviour of non-traded goods prices toproductivity growth. One should emphasise from the outset, that the B-S effect is amedium to long run phenomenon and should thus be viewed as a long run tendencythat might be perturbed in the long run by monetary factors.165How relevant is this phenomenon? The ECB (1999) claims that a number of recentpapers have found evidence in favour of the B-S hypothesis. Typically, thesestudies have used econometric techniques to detect the existence of long-runrelationships (co-integration) between relative price levels and relative productivity.In this framework, the direction of the applied studies has been twofold.A first class of studies focuses on the relationship between long-run changes inrelative prices and productivity differentials across countries, while another analysesthe link between the productivity differentials and inflation differentialsacross sectors within countries. The general conclusion of the first approach is thatthere is evidence of a relationship between the evolution of relative price levelsacross countries and that of productivity differentials. Following the second approach,a clear causality between productivity growth in the traded goods sectorand inflation in the non-traded goods sector has been identified. Indeed, recentstudies show that, while some of the more restrictive assumptions of the hypothesisare not supported by the data, there is still clear evidence that the B-S effecthas been at work within the Euro area.