The Balassa-Samuelson Effect is an economic theory that explains the relationship between productivity and price levels across countries. It posits that countries with higher productivity in the tradable goods sector will experience higher wage levels, which in turn leads to increased demand for non-tradable goods, causing their prices to rise. This effect results in a higher overall price level in more productive countries compared to less productive ones.
The effect can be summarized as follows:
Mathematically, if represents the price of tradable goods and represents the price of non-tradable goods, the Balassa-Samuelson Effect can be illustrated by the following relationship:
This effect has significant implications for understanding purchasing power parity and exchange rates between different countries.
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