FIW – Forschungskonferenz ‘International Economics‘ Wirtschaftsuniversität Wien 11. 12. 2009

1. Balassa-Samuelson: Still haven’t found what we’re looking for? Trond-Arne Borgersen and Roswitha M. King Østfold University College, Halden, Norway FIW – Forschungskonferenz ‘International Economics‘Wirtschaftsuniversität Wien 11. 12. 2009

2. 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)

3. Officialstanceofthe 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)

4. Whyhave we not found what we are lookingfor? • Is therenothing to find? or • Have webeenlooking in thewrongplaces?

5. 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.

6. 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 computessectoralshares 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 basedmeasuresincreases B-S and anchors it firmlyonthesupply side – wherestructuralshiftsreside

7. 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 usestwokey elements • Relative sector size • Productivity growth differences between sectors But does not exploit relations between them. Our alternative approach: Defining a functional relation between them.

8. Endogenizing the sector size:function of productivitygrowthdifference

9. How productivity growthaffectsstructuralinflation: ProductivityGrowthPass-Through (sectorsizeexogenous/endogenous)

10. 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.

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

12. Long-term transition, the size of the tradable sector and tradable sectorproductivity - restructuring

13. The ScandinavianModel of InflationExpressions for Inflation and Structural Inflation

14. From the literature: 2 variants of definingstructural 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 asstructural inflation over a period of time

15. Ourdefinition of (cumulative) structural inflation

17. Sector size elasticity with respect to productivity growth. Conditions for whenincreased productivity differentialtranslatesintostructural inflation depends on the relationbetween sector size elasticity and the prevailingdistribution of valueaddedbetweensecors.

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

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

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

21. Interpretation of Threshold T

22. 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