Balassa–Samuelson Effect

The puzzle: why are rich countries expensive?

Under purchasing power parity the same good should cost the same everywhere, yet in practice services such as haircuts, restaurant meals and rents cost more in high-income countries, and overall price levels converted at market exchange rates are higher too. Kravis and Lipsey (1983) documented a clear positive correlation between national price levels and income per capita. Roy Harrod (1933) first traced this pattern to differences in productivity, and in 1964 Béla Balassa and Paul Samuelson independently offered refined explanations, which is why the hypothesis is also called the Harrod–Balassa–Samuelson effect.

Theoretical structure

The economy is split into a tradable sector, such as manufacturing, whose goods are traded internationally, and a nontradable sector, such as services, consumed only at home. Tradable prices are equalized across countries by international competition, and wages are equalized across the two sectors by labor mobility. Rich countries have especially high productivity in tradables and hence high wages; because the productivity gap in nontradables is small, paying those same high wages requires higher nontradable prices. The overall price level is therefore higher and the real exchange rate, measured at market rates, is appreciated. Countries with fast tradable productivity growth also tend to see their real exchange rates appreciate over time. Bhagwati (1984) offered a complementary explanation based on factor endowments, and Baumol and Bowen's (1966) cost disease, the rising relative price of services with stagnant productivity, shows the same mechanism from a domestic perspective.

Evidence and implications

De Gregorio, Giovannini and Wolf (1994) found that productivity differentials between tradables and nontradables in OECD countries help explain rising relative prices of nontradables. Froot and Rogoff (1995) and Rogoff (1996) concluded that the effect is one important reason for long-run deviations from PPP, while noting that it does little to explain short-run exchange rate swings. Égert, Halpern and MacDonald (2006) reported that it contributed to real appreciation in Central and Eastern European transition economies, though by less than often assumed, and Chong, Jordà and Taylor (2012) found support for the hypothesis in long-run panel analysis. The effect implies that fast-growing members of a currency union such as the euro area may have structurally higher inflation, and it informs the assessment of developing-country exchange rates, as in Rodrik's (2008) work on real exchange rates and growth.

FAQ

What is the Balassa–Samuelson effect in simple terms?

In rich countries with highly productive manufacturing, wages are high, so services like haircuts or restaurant meals, where productivity is similar everywhere, also cost more, lifting the overall price level.

How does it relate to purchasing power parity?

It explains why national price levels do not equalize as PPP predicts and are systematically higher in higher-income countries.

Sources reviewed: 2026-10-26

References

1. Harrod, R. F. (1933). International Economics. Cambridge: Cambridge University Press.
2. Balassa, B. (1964). The purchasing-power parity doctrine: A reappraisal. Journal of Political Economy, 72(6), 584–596.
3. Samuelson, P. A. (1964). Theoretical notes on trade problems. Review of Economics and Statistics, 46(2), 145–154.
4. Baumol, W. J., & Bowen, W. G. (1966). Performing Arts: The Economic Dilemma. New York: Twentieth Century Fund.
5. Kravis, I. B., & Lipsey, R. E. (1983). Toward an Explanation of National Price Levels. Princeton Studies in International Finance No. 52. Princeton: Princeton University.
6. Bhagwati, J. N. (1984). Why are services cheaper in the poor countries? Economic Journal, 94(374), 279–286.
7. Froot, K. A., & Rogoff, K. (1995). Perspectives on PPP and long-run real exchange rates. In G. Grossman & K. Rogoff (Eds.), Handbook of International Economics (Vol. 3, pp. 1647–1688). Amsterdam: Elsevier.
8. De Gregorio, J., Giovannini, A., & Wolf, H. C. (1994). International evidence on tradables and nontradables inflation. European Economic Review, 38(6), 1225–1244.
9. Rogoff, K. (1996). The purchasing power parity puzzle. Journal of Economic Literature, 34(2), 647–668.
10. Obstfeld, M., & Rogoff, K. (1996). Foundations of International Macroeconomics. Cambridge, MA: MIT Press.
11. Égert, B., Halpern, L., & MacDonald, R. (2006). Equilibrium exchange rates in transition economies: Taking stock of the issues. Journal of Economic Surveys, 20(2), 257–324.
12. Rodrik, D. (2008). The real exchange rate and economic growth. Brookings Papers on Economic Activity, 2008(2), 365–412.
13. Chong, Y., Jordà, Ò., & Taylor, A. M. (2012). The Harrod–Balassa–Samuelson hypothesis: Real exchange rates and their long-run equilibrium. International Economic Review, 53(2), 609–634.