Definition
Balassa-Samuelson Effect
The Balassa-Samuelson effect explains why prices and real exchange rates tend to be lower in poorer countries, because productivity gaps are larger in traded than non-traded sectors.
Rich countries have higher productivity mainly in tradable goods, which lifts wages economy-wide, making services and non-tradables (haircuts, rent) expensive there. Poorer countries like India have cheaper non-tradables, so their currencies look undervalued on PPP.
The effect explains why the rupee buys far more locally than its market exchange rate implies, and why a basket of goods is cheaper in India than in the US, the foundation of the Big Mac index's findings.
Related terms
- Real Effective Exchange Rate (REER)REER is a trade-weighted index of a currency against a basket of partner currencies, adjusted for inflation differences, measuring true competitiveness rather than a single bilateral rate.
- Purchasing Power Parity (PPP)Purchasing power parity holds that exchange rates should equalise the price of an identical basket of goods across countries, so a currency's true value reflects what it can buy.
- Big Mac IndexThe Big Mac index is The Economist's light-hearted gauge of currency valuation, comparing the price of a McDonald's Big Mac across countries to test purchasing power parity.
- Comparative AdvantageComparative advantage is the principle that countries gain by specialising in goods they produce at the lowest opportunity cost and trading for the rest, even if one is better at everything.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.