Balassa-Samuelson: still haven't found what we're looking for?

Abstract

Despite its strong theoretical position when it comes to explaining inflation in transition economies, the empirical merits of the Balassa-Samuelson (B-S) effect are weak. This paper points to three theory-based contributing factors to these weak findings and offers an alternative approach. First, the short-term focus makes B-S prone to underestimating the magnitude of the productivity growth differential. Second, the conventional demand side CPI based sectoral composition reduces the extent to which the productivity growth differential is passed through to inflation. Third, by ignoring the dependence between the two main B-S components, a second downward bias to the productivity growth pass through comes about. The key to our proposed alternative centres around an endogenous relation between the productivity growth differential and sector sizes. The long-run supply-side approach allows us to capture inflation drivers that conventional B-S fails to incorporate. The paper provides a blueprint for future empirical analysis