The Balassa-Samuelson effect was recently mentioned in The Economist magazine and refers to the fact that countries with higher per capita real incomes have a higher real exchange rate. There tends to be more investment and productivity in industries that are producing goods for export – emerging economies. This is in comparison to the service sector which tends to be more domestically based. However, a rise in productivity in the tradable goods sector will tend to drive up wages in this sector and, as labour is assumed to be mobile across sectors, push up wages in the non-tradable sector. As the latter increase is not matched by a productivity increase, it will raise costs and prices in the non-tradable goods sector and thereby lead to a rise in inflation – see diagram below.
With this theory in mind The Economist was debating when China would overtake the US as the world’s largest economy. How quickly the gap narrows depends on three things one of which is the inflation gap between China and the USA. Inflation tends to be higher in fast-growing emerging economies than in slow-growing rich ones. Fast productivity growth in export industries raises average wage costs across the economy, including in non-traded services where productivity is sluggish. This ultimately increases average inflation and the projection from The Economist assumes a 4% inflation rate in China compared to 2% in the US.