The nominal exchange rate is one of the most complex macro-financial variables, as it is both a cause and an effect in the formation of macroeconomic equilibria. Therefore, the nominal exchange rate represents an important variable, both for classical macroeconomic policies and for the macroprudential policy, whose objective is to maintain financial stability.
Beyond the nominal exchange rate, macroeconomists are also particularly interested in the evolution of the real exchange rate. Regarding the determinants of this macroeconomic variable, I will revisit and further develop, from one of my recently published articles, entitled “A conceptual analysis on the evolution of the real exchange rate in Central and Eastern Europe after the outbreak of the pandemic”, the example relating to the pricing of a representative McDonald’s product. In 1986, journalist Pam Woodall from The Economist proposed a novel method of comparing purchasing power between world economies, using as a benchmark the price of the famous McDonald’s Big Mac. Her idea started from the principle of purchasing power parity (PPP). This theory, outlined by members of the Salamanca School as early as the 16th century and then elaborated in its modern form by the Swedish economist Gustav Cassel in 1922, assumes that, in the long run, identical goods should cost approximately the same in different countries, when prices are expressed in a common currency.
Given that McDonald’s is present in many countries and that the Big Mac product has globally standardized characteristics, Woodall argued that price differences between countries can provide an intuitive picture of deviations from purchasing power parity. Thus was born the Big Mac index, published annually by The Economist, which, beyond its initial illustrative purpose, has over time become an informal indicator for the concept of real exchange rate.
Essentially, the real exchange rate reflects the ratio at which goods produced in one economy can be exchanged for goods from another economy. This ratio, which expresses the purchasing power of a currency in terms of foreign goods, is obviously influenced by the nominal exchange rate. Therefore, the real exchange rate shows the relative price of goods in two countries.
Under the PPP theory, the real exchange rate should be 1. In contrast, recent data on the Big Mac index show that the price of a Big Mac in the United States is 5.69 USD, while the price of the same product in China is 3.53 USD. Therefore, the ratio of Big Mac prices in the two countries highlights that the yuan is undervalued by about 38% against the US dollar.
Why these differences? There are many factors that determine deviations from PPP theory and a real exchange rate different from 1. One approach is to decompose the factors of production that contribute to the production of the final good into tradable or exportable goods (tradables) and non-tradable goods (non-tradables). In the context of the previous example, the Big Mac is produced based on a basket of tradable goods, such as meat, bun, or cheese, and non-tradable goods, such as the labor provided by those who prepare and sell the product, the rental of commercial space, utilities, etc. If we further refer to the difference between the price of a Big Mac produced in the United States of America and one produced in China, it is clear that this is determined to a large extent by the differences in the prices of non-tradable goods between the two economies. In other words, it is well known that wages are generally significantly higher in the United States than in China, an aspect that is ultimately reflected in the price of a Big Mac product.
Independently, Balassa (1964) and Samuelson (1964) developed a theory on how productivity evolves in the tradable and non-tradable sectors in transition economies, an aspect that further influences the differences between the prices of tradable and non-tradable goods. In other words, the increase in productivity in the tradable sector determines an increase in wages in this sector. As a result of competition in the labor market, this will further determine an increase in wages in the non-tradable sector, which will then be reflected in an increase in the prices of non-tradable goods. These two dynamics determine a series of transformations of the economy. Therefore, the main prediction of the Balassa-Samuelson effect can be given by the following relationship:
where the lambda percentage it shows the percentage change in the two ratios over time, tr and ntr refer to tradable and non-tradable goods, respectively, while with Prod we denote productivity. In other words, the change in relative productivity over time in the tradable and non-tradable sectors is directly reflected in the change in the ratio over time between the prices of non-tradable and tradable products (here we generally refer to goods and services, without a clear delimitation). Since the aggregate price level in the economy is a weighted combination of the prices of tradable and non-tradable goods, the Balassa-Samuelson effect predicts that when productivity in the tradable sector increases faster than in the non-tradable sector, the aggregate price level and inflation will rise accordingly, and this, in turn, will be reflected in an appreciation of the real exchange rate.
Some works, such as that by Chong, Jordà, and Taylor (2010), also attribute an important contribution to the work of Harrod (1933) for the development of this theory, for which the authors refer to the Harrod-Balassa-Samuelson model. However, since later in this article I will focus on an empirical extension, namely the Balassa-Samuelson-Penn approach, to avoid confusion, I will explicitly label this effect as Balassa-Samuelson.
Since the Balassa-Samuelson model is primarily addressed to economies in transition to different levels of development (although some works, such as the one developed by Nishimura, Takahashi, and Venditti in 2023, address the Balassa-Samuelson problem for the case of an advanced economy, such as Japan), its predictions can automatically be extrapolated to understand the effects of these transformations in relation to economic developments in a developed economy. In fact, Balassa noted in his 1964 work: “As economic development is accompanied by greater inter-country differences in the productivity of tradable goods, differences in wages and service prices increase, and correspondingly so do differences in purchasing power parity and exchange rates.”
This way of looking at the Balassa-Samuelson effect raises even more interest for emerging economies such as our country or other countries in Central and Eastern Europe, which, within the European Union, aim to achieve the status of advanced economies, as is especially the case with the countries in the euro area.
Returning to the predictions of the Balassa-Samuelson effect, they assume that emerging economies have a higher growth rate in tradable sector productivity than advanced economies. In this context, the Balassa-Samuelson effect predicts that:
i) tradable sector productivity is higher in rich countries;
ii) the real exchange rate is higher in rich countries;
iii) the aggregate price level is higher in rich countries;
iv) emerging economies tend to have higher inflation than advanced economies, in general;
v) service prices are lower in less developed countries.
A relevant approach from the perspective of operationalizing the PPP concept is the Penn World Table Project (PWT), which has its origins in the research of Gilbert and Kravis (1954) and Kravis, Heston, and Summers (1978, 1983), respectively. They used data provided by the International Comparison Program (ICP) to build a global basis for economic comparison. The main purpose of the PWT is to transform GDP values expressed in national currency into estimates that can be used to make comparisons between countries, using PPP. Kravis, Heston, and Summers (1978) first highlighted the so-called Penn effect (hence the name Balassa-Samuelson-Penn used in some works, such as that of Stahler and Subramanian, 2014), according to which rich countries tend to have higher price levels, i.e. a more appreciated real exchange rate. This finding is compatible with the conclusions subsequently formulated by Rogoff (1996), who confirms the existence of the effect, but analyzes it in the context of the persistence of deviations from purchasing power parity (PPP puzzle).
Therefore, the Balassa-Samuelson model offers a perspective on the irreversible transformations that occur within the process of convergence of an economy towards various stages of development, as well as a sectoral perspective. In contrast, Froot and Rogoff (1985) propose a structural model where they approach the production of tradable and non-tradable goods differently in order to highlight the different nature of the capital, labor, and productivity required to produce the two types of goods. According to Froot and Rogoff (1985), the relationship describing the Balassa-Samuelson effect can be rewritten as follows:
where labor_ntr shows the share of labor in the production process (Cobb-Douglas production function) for non-tradable goods (a similar interpretation for labor_tr). Under the above relationship, according to the Balassa-Samuelson effect, as long as the contribution of labor to the production process of non-tradable goods is higher than in the tradable sector (a situation often encountered), then even a similar increase in productivity in the two sectors will determine an increase in the ratio between the prices of non-tradable and tradable products, leading to an appreciation of the real exchange rate.
Regarding these aspects, Baumol and Bowen (1966) emphasize that a series of labor-intensive services, such as banking, healthcare, consulting, education, etc., have prices that tend to increase over time, as productivity growth in these sectors is lower than in the case of production sectors in which the capital factor is used more intensively compared to the labor factor.
At the same time, with regard to international comparisons, works such as those by Kravis and Lipsey (1983) or Bhagwati (1984) emphasize that the ratio between the contribution of capital and labor factors in the production process is higher in rich countries. The two previous remarks explain why services are generally cheaper in countries with less developed economies.
From the above remarks on the Balassa-Samuelson effect, it can be deduced that it provides a detailed picture of the convergence process of a country towards different stages of development. Thus, the Balassa-Samuelson effect (both in its original form and subsequent extensions) predicts a series of irreversible transformations of the economy during the convergence process. These irreversible changes concern the real exchange rate, wages, the price level in the economy, the allocation of labor, etc.
In the case of our country, beyond macroeconomic concepts such as those mentioned above, significant changes can be observed in the way economic activities are conducted compared to ten years ago. We can cite as an example the increasing appetite, especially among young people, for providing services as independent professionals rather than within companies (sports coaches, content creators, consultants, etc.). It is obvious that these services are based mainly on the labor factor (service-intensive goods). At the same time, the prices of these non-tradable goods have increased significantly compared to their levels ten years ago. In contrast, there is a lower appetite among young people to work in factories, where tradable goods are produced.
Therefore, the materialization of the Balassa-Samuelson effect has been evident through a series of irreversible transformations related to rising labor costs, labor migration, the efficient allocation of capital within the economy, and evolving growth models. In order to find efficient and robust solutions regarding sustainable economic development and/or the efficient correction of imbalances, such as the external imbalance, an adequate understanding of the convergence process is necessary. Through the perspective of the Balassa-Samuelson effect, it is also highlighted that Romania’s convergence process meant the gradual increase in labor costs in relative terms. Therefore, exports and external competitiveness can no longer rely on cheap labor, but must pursue sustainable growth in productivity and efficiency. In this context, the appreciation of the real exchange rate and the increase in labor costs, prospected by the Balassa-Samuelson effect, are implicit developments of the convergence of the Romanian economy.
Moreover, low labor costs cannot remain a desideratum for a country aiming for sustainable economic growth and social well-being. In this regard, China’s example is relevant, a country that has had an impressive convergence process, with accelerated growth starting from the level of an agrarian economy and becoming the second largest economy in the world.
In an extremely interesting paper in my opinion, entitled The Neoclassical Growth of China, Fernández-Villaverde, Ohanian, and Yao (2023) use a neoclassical Ramsey-Cass-Koopmans model of economic growth to investigate China’s economic performance between 1995 and 2019, compared to the economic performance of the United States of America. At the same time, the paper investigates how the performance of the Chinese economy compares to other economic success stories in the Asian area.
Precisely to ensure a fair assessment of economic growth, the evolution of GDP per capita was analyzed, as it is a more appropriate indicator that reflects whether the economy is developing for the real benefit of the population and contributing to higher levels of well-being. For economists, GDP per capita is important for assessing the process of economic convergence, providing information on the dynamics of productivity and quality of life indicators.
The chart above shows the evolution of real GDP per capita (logarithmically scaled) for China, Japan, South Korea, and Taiwan. The data clearly show that China’s trajectory is very similar to that of the other three East Asian economies, considered success stories. It can be seen from the chart that about 25 years after reaching middle-income status, China, Japan, and Taiwan have reached similar levels of real GDP per capita. The only exception is South Korea, which has made somewhat faster progress. These observations suggest that China’s real GDP growth rate does not differ significantly from that of these economies.
On the other hand, it should be noted that China’s growth process began much later, at a time when GDP per capita in developed economies such as the US was already considerably higher. This gave China the advantage of having access to a more advanced technological frontier for the recovery process. However, the graph above highlights that China’s evolution is less spectacular compared to that of other economies. In 1995, China’s GDP per capita was 6.6% of that recorded in the US, and after 25 years, in 2019, this ratio increased significantly, but reached only 25%. At the same time, Fernández-Villaverde, Ohanian, and Yao (2023) emphasize that, in the context of the model used, in 2100, China’s GDP per capita could converge to a level of only 44% of that recorded in the US. Last but not least, the authors estimate that the growth rate of the Chinese economy will decline significantly, falling below that of the US economy, mainly as a result of stronger productivity growth in the American economy. Therefore, the significantly lower level of labor costs in China was not a sufficient condition to achieve higher performance compared to other economies in Asia or the United States of America, despite China’s remarkable technological progress.
Economic development and the increase in welfare in society are generally reflected in the growth of GDP per capita, an indicator frequently used to monitor the convergence process. At the same time, the evolution of the real exchange rate is often used to assess the external competitiveness of an economy. The Balassa-Samuelson-Penn effect describes how natural the increase in the real exchange rate is as a result of irreversible transformations occurring at the sectoral level. Moreover, competitiveness must be investigated outside of these natural transformations, as Stahler and Subramanian (2014) point out.
In the graph above we find the evolution (annual data) of GDP per capita at purchasing power parity and real exchange rate approximated by the REER measure (left scale) in the case of our country. Both variables are expressed as fixed-base indices in 2015. It can be seen that both indices show similar trends starting with 2017, but the growth rate of the GDP per capita index clearly exceeds that of the REER index.
For a clearer picture of the common factors typical of the convergence phase that impact both GDP per capita and the real exchange rate, we extracted the cyclical component from the two timeseries (in this sense, we used the one-sided version of the Hodrick-Prescott filter, where the lambda smoothing parameter was calibrated to 100 given the annual frequency of the data). Figure 4 shows the similar trend followed by the cyclical components of GDP per capita and the REER measure for the real exchange rate starting with 2017. Until the beginning of the Covid-19 pandemic, the cyclical component of the GDP per capita variable manifested changes of a magnitude significantly higher than that observed in the case of the real exchange rate. In contrast, after the outbreak of the pandemic, the two cyclical components recorded very close developments, both in terms of trend and magnitude. So, at first glance, we could conclude that transformations of the economy like those described by the Balassa-Samuelson-Penn effect could be more evident after 2017. Specifically, after 2017, the correlation between the two cyclical components increases significantly compared to the previous period, to approximately 30%.
However, I would like to emphasize that this statement is not a verdict, but only an empirical observation based on a short-term analysis. Of course, an evolutionary trend can be identified, but many specialized studies emphasize that it is preferable that the different forms of the Balassa-Samuelson effect be tested over the long term, or, in this case, the horizon of just seven years is not sufficient and must be extended through future research for a solidly grounded conclusion.
In conclusion, I will provide a short example that I consider eloquent to synthesize the convergence process through a normative interpretation of the Balassa-Samuelson effect. We consider that given a level of nominal income (I) and a price level (P), the quantity of goods (C) that we can purchase is: C = I/P. The aggregate price index P represents a weighting between the prices of non-tradable goods (Price_ntr) and tradable goods (Price_tr). Let us assume that the share of non-tradable goods is 30%. In line with the Balassa-Samuelson effect and its extensions, the convergence process brings an increase in income of 15%, in the price of non-tradable goods of 20%, and in the price of tradable goods of 10%. What will be the effects on the welfare of society in terms of the goods it can purchase?
Therefore, according to the example considered, the convergence process, although it leads to an increase in income by 15%, the additional welfare in the equivalent of purchased goods is only 2%, as a result of the increase in prices. This example aims to emphasize in a simplified manner that the convergence process as a whole, and in particular through the Balassa-Samuelson effect, must be investigated in a comprehensive manner through the net benefit it brings to society. In this regard, Itskhoki (2020) explains in detail how important the real exchange rate is for the general equilibrium of the economy. At the same time, the implicit transformations of the convergence process, as they are described by the Balassa-Samuelson effect, must be studied and understood fully and in an appropriate manner, which takes into account the need for analysis over a relevant period of time in order to identify effective solutions for sustainable economic development and for the efficient correction of imbalances.
Economic convergence does not only imply an advance in incomes, but also inherent price increases, especially in the case of non-tradable goods (especially services, which, in the Romanian economy, as at European level, have a significant share). The advantage of cheap labor dissipates as the convergence process advances and is anyway insufficient to support a consistent, rapid, and sustainable economic advance.
Last but not least, we must bear in mind that irreversible transformations of the economy, as described by the Balassa-Samuelson effect, are not free from risks. A telling example in this regard is the case of Portugal. Reis (2013) provides a detailed analysis of the Portuguese economy before and after the financial crisis, trying to explain the causes of the modest economic performance in the period 2000 – 2012. During that period, Portugal recorded a weaker evolution than that of the United States during the Great Depression or Japan in the “lost decade”. According to Reis (2013), this situation occurred against the backdrop of circumstances described by the appreciation of the real exchange rate, accelerated wage growth, inefficient targeting of capital in the economy, the expansion of the non-tradable sector, the decline in total factor productivity, the excessive accumulation of external debt and the lack of preventive reforms in the pension system. Therefore, the economic transformations described by the Balassa-Samuelson effect must be accompanied by appropriate economic policies, to avoid poor economic performance, as was the case in Portugal.
Productivity improvements and efficient capital allocation are key drivers of enhanced external competitiveness and sustained high convergence rates. At the same time, these factors are fundamental for investments predominantly oriented towards the production of tradable goods. Any depreciation of the nominal exchange rate may have only limited effects, as it also causes negative externalities, such as inflation, higher uncertainty or an increase in the burden of public and private debt. On the other hand, nominal exchange rate depreciation does not automatically imply an improvement in external competitiveness in the short and medium term, unless it is accompanied by productivity gains.
As Paul Krugman pointed out, there is a pitfall in the simplistic interpretation of the issues of productivity growth and competitiveness. In “Competitiveness: A Dangerous Obsession” (1994), he argued: “Suppose that a country finds that although its productivity is steadily increasing, it can succeed in exporting only if it repeatedly devalues its currency, selling its exports ever more cheaply on world markets. Then its standard of living, which depends on its purchasing power over imports as well as domestically produced goods, might actually decline.”Thus, it becomes essential to understand that sustainable development, which involves increased productivity and competitiveness, can be achieved, primarily, through the efficient allocation of capital in the economy.
