FIW – FORSCHUNGSKONFERENZ ‘INTERNATIONAL ECONOMICS‘WIRTSCHAFTSUNIVERSITÄT WIEN 11. 12. 2009

Balassa-Samuelson: Still haven’t found what we’re looking for?

Trond-Arne Borgersen and Roswitha M. KingØstfold University College, Halden, Norway

1

Balassa-Samuelson (B-S) effect: empirically weak

Mihaljek and Klau (2008,2004) B-S explains around 16% of overall CPI inflation in selected east European countries.

B-S explains on average between 0.2% and 2% of annual inflation differentials between east European countries and the euro area.

Also small effects reported by: Egert (2005), Egert (2002a), Egert (2002b), Egert et al (2003) Policy Relevance Breuss (2003) Cipriano (2001) Coricelli & Jazbec (2001) Flek et al (2002) Kovacs (2002)

2

Official stance of the European Commission and ECB

“…notwithstanding its importance, the Balassa-Samuelson effect

should not be overstated when explaining current inflation rates in

the accession countries…. The Maastricht inflation criterion…. will

not be revised to take into account any possible Balassa-Samuelson

effect…”

(Christian Noyer, 2001)

3

Why have we not found what we are looking for?

Is there nothing to find?

or Have we been looking in the wrong places?

4

Three limiting (theory-based) features of B-S

First, mixing of supply-side and demand-side channels ( structural inflation relates to the supply side so analysis should be anchored there)

Second, B-S treats as independent what may be considered strongly related elements: the productivity growth differential between sectors and the sector’s relative magnitude.

Third, structural changes evolve over the longer term. However, by construction, B-S has relatively short-term orientation.

5

First, mixing of supply-side and demand-side channels (B-S is about structural inflation and that relates to the supply side)

Typically B-S computes sectoral shares in CPI rather than in GDP.

Mihaljek and Klau (2008): market based non-tradables account for only 20%-30% in the Baltic States’ CPI basket, while accounting for more than 60% of value added in GDP.

using GDP based measures increases B-S and anchors it firmly on the supply side –

where structural shifts reside

6

Second, B-S treats as independent what in reality are strongly related elements: the productivity growth differential between sectors and the sector’s relative magnitude.

B-S uses two key elements Relative sector size Productivity growth differences between sectorsBut does not exploit relations between them.

Our alternative approach: Defining a functional relation between them.

7

Endogenizing the sector size: function of productivity growth difference

8

0)( where ' TTt qq

How productivity growth affects structural inflation: Productivity Growth Pass-Through (sector size exogenous/endogenous)

9

SE

TTT

PE

TT

STR qqqqqd

Pd)(')()1(

NTTSTR qqP )1(

0)1( T

STR

qdPd

Third, structural changes evolve over the longer term. However, by construction, B-S has relatively short-term orientation.

Long-run supply side transition dynamics come in two layers,

which in the following is referred to as reallocation and restructuring .

Claim: Conventional B-S effect captures the former, but not the latter.

10

The relationship between the size of the tradable sector and its productivity measures - reallocation

11

t

Tq

Tq

Tq

0 0

0 00 0

00

Long-term transition, the size of the tradable sector and tradable sector productivity - restructuring

12

t

Tq

Tq

Tq

0 0

0 00 0

00

The Scandinavian Model of InflationExpressions for Inflation and Structural Inflation

13

STRWNTTW PepqqepP )1(

NTTSTR qqP )1(

From the literature: 2 variants of defining structural inflation

When following the B-S effect over a number of years the literature provides two variants: Constant relative size of the non-tradable sector and time-indexed productivity growth differentials

(1−α)

alternatively, time-indexed productivity growth differentials and time-indexed relative sizes of the non-tradable sector

Both expressions are interpreted as structural inflation over a period of time

14

T

t 1

tNTT qq

T

tt

1

1 tNTT qq

Our definition of (cumulative) structural inflation

15

T

ttNTT

T

tt qq

11

1

16

(1-α)t( )t (1-α)t( ) t+1 (1-α)t( ) t+2 . . (1-α)t( ) T-1 (1-α)t( ) T

(1- α)t+1( )t (1-α)t+1( )t+1 (1-α)t+1( )t+2. . (1-α)t+1( )T-1 (1-α)t+1( )T

(1- α)t+2( )t (1-α)t+2( )t+1 (1-α)t+2( )t+2. . (1-α)t+2( )T-1 (1-α)t+2( )T

(1- α)t+3( )t (1-α)t+3( )t+1 (1-α)t+3( )t+2.

.(1-α)t+3( )T-1 (1-α)t+3( )T

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

(1- α)T-1( )t (1-α)T-1( )t+1 (1-α)T-1( )t+2 (1-α)T-1( )T-1

(1-α)T-1( )T

(1- α)T( )t (1-α)T( )t+1 (1-α)T( )t+2 (1-α)T( )T-1 (1-α)T( )T

NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq NTqTq

T

ttNTT

T

tt qq

11

1

NTT qq

Sector size elasticity with respect to productivity growth. Conditions for when increased productivity differential translates into structural inflation depends on the relation between sector size elasticity and the prevailing distribution of value added between secors.

17

0T

STR

qdPd

1TqEl 0Tq

1TqEl 0Tq

T

TT q

qqEl

)('

Each of the curves represents a given relationship between value added in the tradable and the non-tradable sector.

18

i

ii

1*

When the cumulative productivity growth differential makes structural inflation exceed a threshold (T), the distribution of value added changes...........the curve shifts.

19

T

T

t

t

t

CT

STR*

CT

STR*1

*

dqdP iff ˆ

dqdP iff

Condition for long-term transition. There is a critical value for the growth rate of structural inflation that can bring about transition.

20

TqdPd

CT

STR

TqEl T

1

Interpretation of Threshold T

21

T

ttNTTt

T

ttNTT

T

tt qqqqT

111

)()1(1

Our approach departs from standard B-S analysis in the following ways:

We endogenize the relative sector sizes by defining them as a function of the productivity growth differentials.

We introduce leads and lags into the relation between productivity growth differentials and relative sector sizes, thereby capturing not only instantaneous effects, but also the effects of larger longer-term shifts in the structure of an economy.

We distinguish between short-term dynamics motivated by profit seeking economic agents under a given interval of sectoral composition, and long-term dynamics representing shifts in the prevailing interval of sectoral composition. We link these two dynamics.

We define transition as shifts of relative sector sizes in favor of the non-tradable sector

22