In celebration of thirty years of the Balassa-Samuelson model, this paper attempts to provide an appraisal of the static theory of Balassa (1964) and Samuelson (1964) by embedding it in an explicitly dynamic general equilibrium setting. The paper’s appraisal of this model focuses on two of its key implications; namely that, (i) cross-country differences in the relative price of nontradables reflect differences in the relative marginal productivity of labor of tradable and nontradable sectors, and (ii) cross-country differences in the level of real exchange rates are explained by differences in the relative price of nontradables. These two propositions are developed as long-run, balanced-growth, implications of a two-country intertemporal equilibrium model and several tests are conducted to examine their empirical relevance. For the empirical analysis the authors identify restrictions imposed on the cross-sectional, low-frequency behavior of the data implied by the model, and construct a cross-country sectoral database from existing OECD data to conduct econometric tests based on panel data methods.
The empirical analysis suggests that the Balassa-Samuelson proposition that cross-country differences in long-run domestic relative prices of nontradables are determined by differences in the ratio of long-run sectoral marginal products of labor cannot be rejected by the data. However, the analysis also indicates that long-run relative prices (as measured in the data or as predicted by regressions) are of little help in explaining long-run, cross-country differences in the level of real exchange rates based on CPIs or GDP deflators. Thus, while the paper finds that the Balassa-Samuelson general equilibrium model performs well as a theory of relative prices, it indicates that the model seems unable to account for long-run deviations from PPP. The authors state that this finding echoes a quotation by Paul Samuelson that prefaces the paper: “Unless very sophisticated indeed, PPP is a misleading pretentious doctrine, promising us what is rare in economics, detailed numerical predictions.”