The Balassa–Samuelson effect in Romania – The role of regulated prices

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www.elsevier.com/locate/ejor

European Journal of Operational Research 194 (2009) 873–887

O.R. Applications

The Balassa–Samuelson effect in Romania – The role of regulated prices

Ionut Dumitru a,b,*, Ionela Jianu a

a Academy of the Economic Studies Bucharest, Romaniab Research, Raiffeisen Bank, Romania

Received 6 October 2006; accepted 18 December 2007Available online 31 December 2007

Abstract

Due to the Balassa–Samuelson effect, the candidate countries to the European Monetary Union face a possible conflict between theeffects of tradable productivity increase on inflation and on the appreciation of the real exchange rate on one hand, and the Maastrichtcriteria regarding inflation and exchange rate stability on the other hand. A restrictive monetary policy could succeed in reaching infla-tion criteria, but only with the cost of slowing down real convergence. This paper deals with the Balassa–Samuelson effect in Romania.The main conclusion of the paper is that in the period 1998–2006 the average annual rate of inflation generated by the Balassa–Samuel-son effect in Romania was on average 0.6% in the case of the classical model. Due to the existence of government-regulated prices (mostlynon-tradable goods) accounting for as much as 21% of the CPI basket in Romania – the price of non-tradables has increased by less thanin the case those prices were market prices. If we include these regulated prices in non-tradable, which is named by us extended model, theimpact of Balassa–Samuelson on inflation could have been on average 2.46%. Therefore, the Balassa–Samuelson effect is expected toresult into higher inflation with future price liberalization for non-tradables.� 2007 Elsevier B.V. All rights reserved.

JEL classifications: E31; F31; C15; F15

Keywords: Balassa–Samuelson effect; Convergence; Relative prices; Regulated prices; Productivity differential

1. Introduction

The huge gap between Romania and European Union interms of GDP per capita (Fig. 1) requires rapid growth inproductivity in order to accelerate the catching up process.In the transition process towards a market economy, thecountries from the Central and Eastern Europe revealeda considerable growth in productivity, especially in indus-try. Nevertheless, this development was accompanied bya higher price increase in non-tradable sector than in trad-able sector and by an exchange rate appreciation.

The phenomenon described above corresponds withwhat Balassa (1964) and Samuelson (1964) presented in

0377-2217/$ - see front matter � 2007 Elsevier B.V. All rights reserved.

doi:10.1016/j.ejor.2007.12.026

* Corresponding author. Address: Academy of the Economic StudiesBucharest, Romania. Tel.: +40 723566376.

E-mail addresses: [email protected], [email protected](I. Dumitru), [email protected] (I. Jianu).

their seminal papers and what is called as the Balassa–Sam-uelson effect in the literature.1 Generally speaking, in atransition economy and even in a developed economy,the productivity growth in the tradable sector is higherthan in non-tradable sector. The huge gap between produc-tivity levels in Romania compared with European Union isthe main driver of the convergence in productivity level(Fig. 2), being a reason to consider the Balassa–Samuelsoneffect as a potential factor explaining the high rate of infla-tion in Romania and the real exchange rate appreciation inRomania. At the same time, it is important to know howthe future increase in productivity needed for the real con-vergence process would influence the rate of inflation andthe appreciation of the exchange rate.

1 The Balassa–Samuelson effect is also known as the Harrod–Balassa–Samuelson effect.

mailto:[email protected]



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PortugalMalta

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SwitzerlandIceland

Fig. 1. GDP per capita at PPS, (EU-25 = 100,2005). Source: EUROSTAT.

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Fig. 2. Labour productivity (GDP at PPP per number of employees) (EU-25 = 100,2005). Source: EUROSTAT.

874 I. Dumitru, I. Jianu / European Journal of Operational Research 194 (2009) 873–887

Due to wage equalization, the increase in productivity inthe tradable sector will trigger an increase in wages in thewhole economy, and thus an increase in relative prices of

non-tradable sector. If the productivity in the tradable sec-tor of a country will increase faster than productivity in thetradable sector in its trading partners, the inflation rate will

I. Dumitru, I. Jianu / European Journal of Operational Research 194 (2009) 873–887 875

be higher than the inflation rate in the partner country andconsequently the exchange rate will appreciate in real terms.

In the last years, many research papers dealing with theBalassa–Samuelson effect estimated using econometrictechniques the impact on inflation and on exchange rateespecially for transition countries. Nevertheless, only fewstudies include only Romania in their focus. However,there are some panel studies including a larger set of tran-sition economies that includes Romania also (Taylor andSarno, 2001; Begg et al., 1999; Coricelli and Jazbec, 2001and others).

This paper is organized as following. Section 2 presentsthe theoretical model. Section 3 presents the results of esti-mations for Romania. In Section 3 the data used for Roma-nia are presented and the basic hypotheses of the theoreticalmodel are empirically examined. Also, the internal andexternal transmission mechanism of the Balassa–Samuelsonis econometrically estimated and the impact on inflationand on exchange rate is evaluated. Section 4 presents somecomments related to implications on the future participa-tion of Romania in the ERM2 and on the convergenceprocess and Section 5 provides some concluding remarks.

2. The Balassa–Samuelson model

In his original presentation, the Balassa–Samuelsoneffect was intended to explain the developments in the realexchange rate in developing countries. Currently, thismodel is also used to explain the structural part ofinflation.

The theoretical model has some fundamental hypothe-ses. First, the economy is divided in two parts: the tradablesector (the open sector) and the non-tradable sector (theclosed sector). Second, the price in the tradable sector isdetermined on the international market due to trade inte-gration, meaning that the absolute and relative version ofPPP is valid for the tradable sector. Finally, the lasthypothesis is that the wages will equalize in these two sec-tors. If the wage level in the open sector is driven by pro-ductivity developments, an increase in the productivity inthe tradable sector will trigger an increase in wages. Dueto labor mobility and trade unions power, the wages inthe closed sector will increase also, despite the fact thatthe productivity in this sector does not justify this increase.As a consequence, in order to ensure financial equilibrium,the prices in the closed sector will increase and the relativeprices will increase also. Moreover, the headline inflationwill increase through non-tradable prices.

According to Egert (2003), we can write the productionfunction in these two sectors of the economy in a Cobb–Douglas functional form2:

Y T ¼ AT � ðLTÞc � ðKTÞ1�c;

Y NT ¼ ANT � ðLNTÞd � ðKNTÞ1�dð1Þ

2 The detailed theoretical model is presented in Appendix.

where A: total factor productivity (TFP); L: labor force; K:capital; T and NT stands for tradable and non-tradablesectors.

The profit functions for the two sectors are

GT ¼ P T � Y T � R� KT � W � LT;

GNT ¼ P NT � Y NT � R� KNT � W � LNT;ð2Þ

where P: price level; G: profit level; R: interest rate; W:wage level.

Using the profit maximization objective, the marginalproduct of labor and capital will be equal with the wageand interest rate, respectively:

AT � c� KT

LT

� �1�c

¼ W

P T;

ANT � d� KNT

LNT

� �1�d

¼ W

P NT;

ð5aÞ

AT � ð1� cÞ � LT

KT

� �c

¼ R

P T;

ANT � ð1� dÞ � LNT

KNT

� �d

¼ R

P NT:

ð5bÞ

Using notations w; p; a; m instead of DWW ; DP

P ;DAA ;

D KLð Þ

KL

, we canobtain:

w ¼ aT þ ð1� cÞ � mT; ð7Þ

w ¼ pNT þ aNT þ ð1� dÞ � mNT; ð8Þ

aT ¼ c� mT; ð9Þ

aNT ¼ d� mNT � pNT: ð10Þ

Finally, we can obtain the internal transmission mechanismof the Balassa–Samuelson effect, meaning the relationshipbetween the productivity differential and relative prices ofnon-tradable goods:

pNT ¼ dc� aT � aNT: ð16Þ

In other words, Eq. (16) presents the impact of productivityincreases on inflation in non-tradable sector. Assumingthat d = c, in practice, Eq. (16) is tested as following:

ðpNT � pTÞ ¼ f ðaT � aNTÞ: ð16aÞIf all three hypotheses are valid and Eq. (16a) is valid alsofor the foreign country (the trading partner country), theincrease in productivity differential and the change in rela-tive prices should be related:

ðpNT � pTÞ � ðpNT� � pT�Þ ¼ ðaT � aNTÞ � ðaT� � aNT�Þ:ð17Þ

The headline inflation could be written as

p ¼ a� pT þ ð1� aÞ � pNT: ð18ÞUsing the relation of the real exchange rate q = e + p* � p

we obtain

0%

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80%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006H1

Export UE-15 Import UE-15 Foreign trade UE-15

Note: foreign trade is defined as export+import

Fig. 3. The share of import and export with EU-15 in total export and import. Source: National Institute of Statistics (NIS). Note: foreign trade is definedas export + import.

4 Fuels had administered prices till end 2004 when the Petrom company,


q ¼ eþ pT� � pT þ ð1� aÞðpT � pNTÞ � ð1� a�ÞðpT� � pNT�Þ:ð22Þ

From Eqs. (17) and (22) we can state that when the produc-tivity differential in the home country overpasses the pro-ductivity differential from the foreign country, higherdomestic non-tradable inflation will be translated in higherinflation than in the partner country and the exchange ratewill appreciate in real terms.

3. Results

3.1. Data

The benchmark country for estimations is the euro zone.This is explained by the fact that the main part of the for-eign trade of Romania is with the European Union. Theshare of trade with EU in total trade of Romania hasincreased from a level of around 30% at the beginning oftransition to almost 60% in 2006 (Fig. 3). The choice ofeuro zone as the ‘‘benchmark” country is also motivatedby the interest of Romania to converge towards this zoneas a part of his strategic economic development.

The distinction between tradable and non-tradable sec-tors for Romania, as well for other countries is one ofthe hardest decisions in estimating the Balassa–Samuelsoneffect. If at all possible, the distinction between the two sec-tors should be done analyzing each category of goods. Acomprehensive analysis of this decomposition is done inKnight and Johnson (1997). Some studies3 use the shareof each economic sector in total exports as an indicatorfor the tradable characteristic of the sector. According withHalpern and Wyplosz (2001), if more than 10% of the pro-duction of a sector is exported, this sector will be consid-ered as tradable.

In constructing the productivity series, due to the factthat the main part of the exported goods from Romaniais represented by industrial goods, we will consider the

3 For example De Gregorio et al. (1994).

industrial sector as being tradable and the services sectoras being non-tradable. This distinction is very often usedin empirical studies which deal with the estimation of theBalassa–Samuelson effect (Tica and Druzic, 2006).

Regarding the price series, according with the classicalBalassa–Samuelson, in the open and closed sector weshould have only market-based prices, i.e. only pricesdirectly linked to wage costs. This is a result of the fact thateconomic agents from the two sectors have a profit maxi-mization objective and they set the price accordingly.Nevertheless, in the Balassa–Samuelson literature, mostresearchers simply assume that services prices are non-trad-able (including services with regulated prices) and theremaining part of CPI prices are tradable (Tica and Druzic,2006).

We use in estimations two approaches for the non-trad-able prices in Romania:

� The first approach is considering the non-tradable pricesas market services (services without administered ser-vices prices) prices, being considered in the text as non-

tradable1 and tradable prices are the remaining part ofCPI without administered prices (food prices and non-food prices without administered prices).� The second approach is considering the non-tradable

prices as all services prices and other administered pricesfrom non-food prices (electric and thermal energy, gasand fuels4), being considered in the text as non-tradable2

and tradable prices as the remaining part of CPI.

We should make some comments regarding prices forthe open and closed sector in Romania. In the firstapproach we have a classic Balassa–Samuelson effect andin the second approach we have an ‘‘extended” Balassa–Samuelson effect. The administered prices (prices regulated

the largest oil company in Romania was privatized, and OMV fromAustria bought Petrom. Starting 2005 the fuels price is a free (market)price.

05

101520253035404550556065

1998 1999 2000 2001 2002 2003 2004 2005

GDP Food Consumer goods Consumer services Housing, water,electricity,gasan

Fig. 4. Price level in Romania (EU-25 = 100). Source: EUROSTAT.

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Total CPIRegulated pricesMarket services (nontradable1)Market services+regulated prices (nontradable2)

Fig. 5. Developments in inflation, market services and regulated prices.


by the Government), representing currently 21% of the CPIbasket, are in a rising trend in Romania as a result both ofa price convergence towards EU level,5 the price level inRomania being overall much below than in the EU(Fig. 4), and in order to cover production costs.

As in the case of other countries from Central and East-ern Europe (see Egert, 2003), regulated prices inflation inRomania was persistently above average inflation(Fig. 5). In addition, the non-market (government-regu-lated) component of non-tradable prices outpaces marketnon-tradable prices. For instance, regulated prices grew1.7 times faster than market-services prices and 2.7 timesfaster than CPI inflation.

If the regulated prices were free prices, then the regu-lated prices will increase even more, and if we do not

5 For example, according to the negotiations of the Romanian Govern-ment with European Commission, Romania should raise the price until2008 in the case of gas in order to equalize the price of gas from internalproduction with the import price and to cover production costs in the caseof energy.

include these prices in non-tradable prices, the Balassa–Samuelson effect would be underestimated (Egert, 2003).6

Moreover, in the future the regulated prices would be freeprices (market prices) and are expected to behave similarlyand therefore can be considered as normal market servicesin the long-run.

Regarding the inclusion of regulated prices in non-trad-able prices when estimating the Balassa–Samuelson, we canfind in the literature some authors that included the regu-lated prices and some other that excluded them. Forinstance, in the case of Hungary Kovacs (2002) assumedthat regulated non-tradable prices are affected by the pricebehavior of market non-tradables and we should add theminto non-tradables when we estimate Balassa–Samuelsoneffect. This assumption seems to be reasonable for authors,as regulated prices cannot differentiate from market pricesin the longer term. Egert et al. (2002) argue that the regu-lated prices should not be included but nevertheless, they

6 The regulated prices are most likely non-tradable prices, being in themain part services.


estimated the Balassa–Samuelson effect for some countriesincluding all services as non-tradable. Egert (2007) arguesalso that sectors in which prices are not governed by mar-ket forces (government-regulated prices) should beexcluded, because prices would not react to productivitychanges in the way they would in a sector driven by marketforces. Nevertheless, the author acknowledged that pricedevelopments of regulated services cannot escape in thelong run from the wage pressures of the tradable sectorattributable to the Balassa–Samuelson effect. Accordingto Egert (2003), there are good reasons to think that theregulated or public non-tradable sectors will similarlybehave in the long-run because of some spill-over effectsfrom market-driven non-tradable sectors towards the restof the closed sector of the economy. He included regulatedprices in non-tradables and obtained a higher impact of theBalassa–Samuelson effect compared with the situationwhen they are excluded.

For the euro zone, given the very low share of regulatedprices in HICP, we ignore them and we consider the ser-vices prices as non-tradable prices and tradable prices theremaining part of HICP.

To assess the Balassa–Samuelson effect in Romania, weused statistical data regarding the evolution of labor pro-ductivity,7 relative price development for non-tradablegoods and real exchange rate. The data used are quarterlycovering the period 1997:Q1–2006:Q2.8 All data series arein natural logarithm and seasonally adjusted using X-12ARIMA.

The source of data is the National Institute of Statisticsand National Bank of Romania for data regarding Roma-nia and ECB and EUROSTAT for data regarding eurozone.

3.2. Empirical testing of the Balassa–Samuelson theoretical

hypotheses

In this section the basic hypotheses of the Balassa–Sam-uelson effect are tested empirically prior to the econometricanalysis for Romania.

Regarding the free movement of capital between the twocountries, since 1998 Romania has had full current accountconvertibility in line with art. VIII of IMF. Starting 1999the medium and long term capital flows were liberalized.Until September 2006, all flows of capital were liberalizedprogressively.

Regarding the free movement of labor force, if the wagelevel is correlated with the productivity in the tradable sec-tor, a faster growth in the wage level in the open sectorwould trigger a labor force migration from services to

7 As a proxy for total factor productivity (TFP). The labor productivitywas calculated as the ratio between gross value added in real terms and thenumber of employees in the respective sector.

8 The choice of the sample is mainly motivated by the lack of data forGDP at a quarterly basis before 1997. Before 1st January 1999, we usedthe exchange rate ROL/ECU.

industry. In Romania, this process is a little bit misleading.The number of employees in industry decreased continu-ously in Romania, and at the same time the number ofemployees in services increased. The decrease in the laborforce in industry in Romania is due mainly to the restruc-turing process in this sector and the migration abroad ofRomanians.9

The hypothesis of a faster increase in productivity in thetradable sector than in non-tradable sector in Romania istested empirically in Fig. 6. As we can see from the graph,this hypothesis is valid, the labor productivity in industryincreasing faster than in services sector.

It should be stated that the large increase in productivityin industry since 1997 has been largely due to the decreasein the number of employees after layoffs resulted from therestructuring process started in the first part of the period(Fig. 7), but after 2000 the large increase in industrial out-put explained to a larger extent the increase in productivity,the number of employees showing some signs of stabiliza-tion in the last years.

In order to study the transmission mechanism betweenproductivity growth in tradable sector and the growth inprices in non-tradable sector, we investigate first the rela-tionship between real wages10 and productivity in the trad-able sector. To do this, we calculated the real wage inindustry based on three price indices: industrial producerprice index (PPI), tradable price index and consumer priceindex.

As we can see from Fig. 8, the real wage in industry andproductivity had similar developments in the period ana-lyzed. Competitiveness gains compared with the previousyear by a lower increase in real wage compared with theincrease in productivity (meaning a decrease in unit laborcost ULC) were recorded in 1999, 2000 and 2003, the otheryears being generally characterized by a loss in competi-tiveness. Nevertheless, at the level of the year 2006 the pro-ductivity increase with fixed base (1997:Q1 = 1) is higherthan the increase in real wage, allowing for a competitive-ness advantage of the Romanian exported products.

The next step is to see how the wages in the two sectorsare equalizing. As we can see from Fig. 9, the nominalgross wages in services increased faster, after being belowthe level from industry, and are currently higher than inindustry.

If we take a closer look at the services sector wages, thehighest increase is in the financial intermediation sector. Ifwe eliminate this sector from the services, the wage equal-ization is more evident, the relative wage being currentlyvery close to 1.

Regarding the assumption of the increase in rela-tive prices of non-tradable sector, Fig. 10 validates this

9 Currently, some estimations show that the number of Romaniansworking abroad is above 2 millions.10 Nominal wages from services are calculated as a weighted average of

wages in each services subsector using the number of employees in eachsubsector as weights.

0.90

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Tradable productivityNontradable productivity

Productivity differential

Fig. 6. Labor productivity in Romania (fixed base index, 1997:Q1 = 1). Source: NIS, author’s own calculations.

0.600.650.700.750.80

0.850.900.951.00

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Number of employees in industryThe value added in industry in real terms (l.h.s)

Fig. 7. Development in employment and value added in industry (fixedbase indices, 1997:Q1 = 1).


assumption. In both sectors, the price level recorded a highgrowth, the gap between them widening starting 1998. Thisis due to the fact that the prices in non-tradable sectorincreased faster than in the tradable sector. The increasein productivity in the open sector allowed for an increasein wages in this sector, and the increase in wages in theclosed sector required an increase in prices to preservethe profit margins.

3.3. The econometric results

Unit root tests indicated that the series are nonstation-ary in levels and stationary in first difference, meaning thatthese series are I(1) processes (the tests were performedusing ADF, Philips–Perron and KPSS).11 This justifiesthe use the Johansen cointegration procedure to identifya cointegration relationship between variables used inanalysis.

The estimations are performed in a number of steps sim-ilar to the methodology used by Egert (2003). First, we esti-mate the relationship between the productivity differentialbetween tradable and non-tradable and the relative prices(non-tradable prices/tradable prices), i.e. the internal trans-mission mechanism, in Romania according to Eq. (16a).

11 Unit root test results can be provided upon request.

Second, if there is a cointegration relationship betweenthe above two variables, we test the relationship betweenthe productivity differential and the real exchange rate(i.e. the external transmission mechanism). This will bedone in two steps, the first being the estimation of the rela-tionship between the difference in productivity differentialsbetween Romania and euro zone and the difference in rel-ative prices (according with Eq. (17)). The second step isthe estimation of the relationship between the differencein relative prices between Romania and euro zone and realexchange rate.

The first cointegration relationship12 estimated is theinternal transmission mechanism and the results are pre-sented in Table 1. According to Table 1, an increase in pro-ductivity in Romania triggers an increase in relative pricesof non-tradable goods. The cointegrating vector is normal-ized to 1 for relative prices. The coefficient of productivitydifferential is statistically significant at 1% confidence levelfor both the two measures of non-tradable prices. The coin-tegration test revealed that between the two variables canbe identified one cointegration relationship (based onJohansen cointegration test).

Imposing a test for a unit value for the coefficient of theproductivity differential in the cointegration vector, theChi-square test reveals that the null hypothesis cannot berejected when we use non-tradable1 prices at 1% confidencelevel and respectively 5% confidence level in the case we usenon-tradable2 prices. This means that the increase in pro-ductivity differential is completely translated into relativeprice increases. The coefficient equal to unity or higherthan unity for the productivity deferential is reasonablefor Romania, as we saw that the wages in services werelower than in industry until 2003, and the services pricesincreased faster when the productivity increased by 1%.

To test the relationship with the benchmark country, weestimated the relationship between the difference in produc-tivity differentials between Romania and euro zone and thedifference in relative prices (Table 2). The results from Table2 indicate that the coefficient of difference in productivity

12 The cointegration tests can be provided upon request.

-6%

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Productivity growth in industry (%, yoy)

Real wage growth based on CPI prices (%, yoy)

Real wage growth based on PPI prices (%, yoy)

Real wage growth based on tradable prices (%, yoy)

1.01.11.21.3

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2.02.12.2

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Productivity growth in industry

Real wage growth based on PPI pricesReal wage growth based on tradable prices

Real wage growth based on CPI prices

Note: Fixed base index, 1997Q1=1

Note: The growth rates are cumulated from the beginning of the year (ytd– year to date) compared with the same period of the previous year

Fig. 8. Developments in productivity and real wages in industry. Note: The growth rates are cumulated from the beginning of the year (ytd – year to date)compared with the same period of the previous year. Note: Fixed base index, 1997Q1 = 1. Source: NIS, author’s own calculations.

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The ratio between wages in nontradables and tradablesTrend

Fig. 9. The wage equalization process. Source: NIS, author’s owncalculations.


differential is statistically significant at 1% confidence levelfor both the two measures of non-tradable prices.

Finally, the relationship between the exchange rate anddifference of relative prices is estimated (Table 3). Again,the coefficient is statistically significant. Combining the

coefficients estimated in Tables 2 and 3, we can concludethat when the difference of productivity differential betweenRomania and euro zone increases with 1%, we can state thatthe exchange rate appreciates in real terms with 1.9% in theapproach with non-tradable1 (2.19784 * 0.862492) in theclassical model and with 1.46% in the approach with non-

tradable2 (3.22485 * 0.455623) in the extended model.The coefficient obtained is a little bit higher than the

unity coefficient suggested by the theoretical model. Theexplanation can be seen in the different weights of tradableand non-tradable goods in CPI in Romania and euro zoneand the fact that not only the non-tradable prices areincreasing in Romania, but the tradable prices too.

3.4. The inflation generated by the Balassa–Samuelson in

Romania

The impact of the Balassa–Samuelson effect in Romaniadepends on the productivity differential, the share ofnon-tradable goods in the CPI basket and the estimatedcoefficient for the relationship between productivity differ-ential and relative prices.

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2.6Tradable pricesNontradable1 pricesNontradable2 pricesRelative prices (Nontradable1 prices/Tradable prices), r.h.s.Relative prices (Nontradable2 prices/Tradable prices), r.h.s.

Note: nontradable1 prices= market services; nontradable2 prices= services+administered prices

Fig. 10. Relative prices in Romania – non-tradable prices/tradable prices (1997Q1 = 1). Source: NIS, author’s own calculations. Note: non-tradable1prices = market services; non-tradable2 prices = services + administered prices.

Table 1Vector error correction for the internal transmission mechanism

Vector Error Correction Estimates Vector Error Correction Estimates Standard errors in ( ) & t-statistics in [ ] Standard errors in ( ) & t-statistics in [ ]

Cointegrating Eq: CointEq1 Cointegrating Eq: CointEq1

LDIFP1_RO(-1) 1 LDIFP2_RO(-1) 1

LDIFW_RO(-1) -1.26433 LDIFW_RO(-1) -1.52963-0.17723 -0.10756

[-7.13403] [-14.2205]

C -0.19917 C -0.14379 Chi-square(1) 8.658436 Chi-square(1) 4.132024 Probability 0.003256 Probability 0.042079

Table 2Vector error correction for the external transmission mechanism step 1



LDIFP1(-1) 1 LDIFP2(-1) 1

LDIFW(-1) -2.19784 LDIFW(-1) -3.22485-0.27997 -0.38794

[-7.85034] [-8.31282]

C -0.10839C 0.089267


The econometric cointegration techniques used in thispaper led to the conclusion that in the period 1998–2006the average annual rate of inflation generated by theBalassa–Samuelson effect in Romania was in the case of

the classical model between 0.1% in 2005 and 1.34% in1999. In the extended model, which is considered moreappropriate by us, the impact on inflation is higher andranges between 0.44% in 2005 and 4.52% in 1999. On

Table 3Vector error correction for the external transmission mechanism step 2



L_CURS_REAL_IPC(-1) 1 L_CURS_REAL_IPC(-1) 1

LDIFP1(-1) 0.862492 LDIFP2(-1) 0.455623-0.13804 -0.08655

[ 6.24815] [ 5.26448]

C -0.19553C 0.032868

Table 4Average annual inflation generated by Balassa–Samuelson effect in Romania

Year Average annual inflation generated by Balassa–Samuelson effect in Romania – classical model (%)

Average annual inflation generated by Balassa–Samuelson effect in Romania – extended model (%)

Average effective annualinflation in Romania (%)

1998 0.71 2.11 59.11999 1.34 4.52 45.82000 0.96 3.83 45.72001 0.69 3.13 34.52002 0.36 1.83 22.52003 0.19 1.09 15.32004 0.33 1.98 11.92005 0.10 0.44 9.02006H1 0.74 3.22 8.6Annual

average1998–2006

0.60 2.46 28


average, the impact of the classical Balassa–Samuelsoneffect on inflation was 0.6% and 2.46% in the extendedmodel (Table 4).

From the analysis we conclude that the productivity dri-ven inflation in Romania has been rather low during theinvestigated period. Using the strict model (the classicalmodel), i.e. weights for market services in CPI (non-trad-able1), we find that while inflation due to the Balassa–Sam-uelson effect peaked in 1999 with about 1.34%, thestructural inflation steadily decreasing to 0.1% in 2005.Taking a broader definition of non-tradables (non-trad-able2) which include regulated prices, the resulting contri-bution to overall inflation is higher.

Our results regarding the impact of the Balassa–Samuel-son are comparable with the results obtained by otherauthors for countries in transition. Although variousauthors use various econometric methods in their papersto assess the Balassa–Samuelson effect and have differentdefinitions for tradable and non-tradable, their resultsmostly confirm the presence of the Balassa–Samuelsoneffect in the observed countries. The estimated contributionof the Balassa–Samuelson effect on inflation is usually inliterature up to 3%. Egert et al. (2002) estimated for the1995–2000 period that the average impact on inflation isof 1.4% for Hungary, 1.8% for Poland, 2.5% for Slovakia,

1.4% for Slovenia, 1.2% for Estonia and 0.8% for CzechRepublic. Kovacs (2002) estimated for the period 1993–2001 for Czech Republic an impact on inflation of 0.1%,for Hungary 1–2%, for Poland 1.2–1.5% and for Slovenia1–2%. Egert (2003) estimated that in Estonia the Balassa–Samuelson on average contributed to inflation from 0.5%to 2%. Egert (2003) estimated also that in the case of usingonly market services as non-tradable (as we used in theclassical model), the Balassa–Samuelson effect is lower thanin the case he used a broader definition of non-tradables (aswe used in the extended model) the resulting contributionto overall inflation is higher, which is also consistent withwhat we obtained in this paper.

Romania is not so often included in the Balassa–Sam-uelson literature and when it is included, the estimationsare based generally on panel data. A separate estimate ofthe Balassa–Samuelson effect in Romania can be found inEgert (2005), which estimated the impact on inflation of0.52% for 1991–2002 period and 1.68% for 1996–2002period.

Whatever the model taken into consideration, in 2005we can see a strong slowdown in the Balassa–Samuelsoneffect impact on inflation in Romania mainly due to thestrong slowdown in the productivity growth in industry lastyear. In the first half of 2006, due to a new strong increase

5%10%15%20%25%30%35%40%45%50%55%60%65%70%

1998 1999 2000 2001 2002 2003 2004 2005 2006H1

Share of nontradable1 in CPIShare of nontradable2 in CPIShare of services in CPIShare of services in GDPShare of services in gross-value added

Fig. 11. The share of non-tradable in CPI and GDP. Source: NIS,author’s own calculations.

Table 5Unit root test for real exchange rate based on tradable prices

Null hypothesis: l_exchange rate_real has a unit root

Exogenous: constant

Lag length: 1 (Automatic based on SIC, MAXLAG = 9)

t-Statistic Prob.*

Augmented Dickey–Fuller test statistic �1.406547 0.5658Test critical values: 1% level �3.670170

5% level �2.96397210% level �2.621007


in productivity, the Balassa–Samuelson effect strengthensagain.

We think that the impact of the Balassa–Samuelsoneffect on inflation in the future would increase due to thefact that the share of services in the CPI basket shouldincrease. Currently, the share of services in the CPI basketis three times lower than in GDP formation (Fig. 11).On the other hand, the share of services in GDP wouldincrease further, and given the current low share in GDPcompared with developed countries, we can expect thisshare to increase as a consequence of the catching-upprocess. This will be the result of the increase in wealthof population and the move of consumption more toservices than to food like in present (the food goods rep-resents currently 40.71% in the CPI basket and services17.04%). Furthermore, given the higher share of servicesin the GDP, we can state that the Balassa–Samuelsoneffect on inflation is higher on the GDP deflator than onthe CPI.

3.5. Real exchange rate appreciation due to the Balassa–Samuelson effect in Romania

Due to the fact that the Balassa–Samuelson effect cre-ates a higher inflation in Romania than in euro zone, thereal exchange rate of Romanian leu appreciates. Accordingto the theoretical model, the Balassa–Samuelson effectcould explain the higher real appreciation of the exchange

2300

3300

4300

5300

6300

7300

8300

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

De0

Real exchange rate_CPI prices

Real exchange rate_tradable pricesReal exchange rate_nontradable2 pric

Fig. 12. Real exchange rate EUR/ROL. Sour

calculated based on non-tradable prices than the apprecia-tion calculated using tradable prices (Fig. 12). If the realappreciation of the exchange rate is fully explained by theBalassa–Samuelson effect, the purchasing power parity(PPP) should be valid for real exchange rate deflated withtradable prices. In other words, the real exchange rate cal-culated using tradable prices should be stationary withouta trend. According to the tests performed, the series is notstationary (Table 5). Consequently, the Balassa–Samuelsoneffect cannot fully explain the real appreciation of theexchange rate, and this conclusion is reasonable given thenumerous interventions of the National Bank of Romaniain the foreign exchange market, given the floating exchangerate regime in Romania and the use of the exchange rate asan antinflationary anchor.

Regarding the impact of the Balassa–Samuelson effecton the real appreciation of the exchange rate, the resultsare presented in Table 6. For assessing the impact, we usedthe average annual increase in productivity, the elasticitycoefficients estimated and the share of the services in CPIbasket. As we can see from the table, the real appreciationof the exchange rate due to the Balassa–Samuelson effectwas between 0.19% and 2.55% in the case of the classicalmodel and between 0.48% and 4.7% in the case of theextended model.

Based on the results obtained in this paper, we can esti-mate also the nominal equilibrium exchange rate drivenby the Balassa–Samuelson effect (Fig. 13). In 2005 thesharp nominal effective appreciation of the exchangerate was higher than the equilibrium appreciation given

c-1

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Real exchange rate_PPI prices

Real exchange rate_nontradable1 priceses

ce: NBR, NIS, author’s own calculations.

Table 6The real appreciation of the exchange rate due to the Balassa–Samuelson effect

Year Average annual real appreciation generated byBalassa–Samuelson effect in Romania – classicalmodel (%)

Average annual real appreciation generated byBalassa–Samuelson effect in Romania – extendedmodel (%)

Average actual annual realappreciation in Romania(%)

1998 1.07 2.03 21.551999 2.01 4.34 �13.142000 1.43 3.68 14.182001 1.03 3.01 0.762002 0.54 1.76 �0.242003 0.29 1.05 �6.372004 0.50 1.91 1.492005 0.14 0.43 16.192006H1 1.11 3.09 9.46Annual

average1998–2006

0.90 2.36 4.88

7000

10000

13000

16000

19000

22000

25000

28000

31000

34000

37000

40000

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Nominal actual exchange rateNominal equilibrium exchange rate model 1Nominal equilibrium exchange rate model 2

Fig. 13. Nominal actual exchange rate EUR/ROL and the equilibrium exchange rate due to the Balassa–Samuelson effect.


the Balassa–Samuelson effect due to the slowdown inproductivity growth and the exchange rate was overvalued.

4. The impact of the Balassa–Samuelson effect in Romania

on the exchange rate policy and the participation to ERM2

The Balassa–Samuelson effect presence suggests a possi-ble conflict between the real exchange rate appreciation ofthe EU and EMU acceding countries and the Maastrichtcriteria regarding inflation and exchange rate stability.Consequently, there is an open question regarding howthese countries will succeed to have an inflation rate belowthe cap of 1.5% above the best three performers in inflationfrom the EU (currently meaning an inflation below 3%)when only the Balassa–Samuelson effect brings around2% in inflation in the candidate countries? The answercould be a very restrictive monetary policy even with theprice of an economic growth slowdown, but the costs interms of real convergence are very high, given the strongneed for real convergence. This observation represents areal dilemma for the monetary authorities from the candi-date countries, especially for those with a fixed exchangerate. For those with a floating exchange rate this problemis less accentuated and the equilibrium could be obtained

by allowing a nominal exchange rate appreciation, threat-ening the ERM2 exchange rate stability criteria. Neverthe-less, the Balassa–Samuelson effect should be sufficientlyhigh in order to overpass the 15% band of ERM2.

5. Concluding remarks

The occurrence of the Balassa–Samuelson effect in thecandidate countries to the European Monetary Unionemphasizes a possible conflict between the effects of thecatching up of the traded goods sector’s productivity,needed for real convergence, on inflation and on the appre-ciation of the real exchange rate on one hand, and theMaastricht criteria regarding inflation and exchange ratestability on the other hand. The Balassa–Samuelson effectcould make it impossible to achieve either the inflation cri-terion of maximum of 1.5% higher than the three EU mem-ber countries best performers in terms of inflation(excluding countries with deflation), or the exchange ratecriterion, i.e. that the exchange rate should be fixed for 2years within the ERM2 band of +/�15% around the cen-tral parity. A restrictive monetary policy could succeed inreaching inflation criteria, but only with the cost of slowingdown real convergence.


This paper estimated the importance of the Balassa–Samuelson effect in Romania and its impact on inflationand real exchange rate appreciation. The paper showedthat the basic assumptions of the theoretical Balassa–Sam-uelson model are fulfilled for Romania.

One very important issue in the paper was the classifica-tion of the tradable and non-tradable prices. We used twomeasures of non-tradable prices. The first measure corre-sponds with the classical Balassa–Samuelson model anduse as non-tradable prices only market-based prices(excluding regulated prices) and the second measure whichwe called an extended Balassa–Samuelson model includedalso the administered prices from the CPI basket as non-tradable prices. We considered the second approach moreappropriate for Romania’s case from the European inte-gration perspective, the Balassa–Samuelson effect being,and the results of the paper confirmed, driven more bythe convergence of prices (market and regulated prices)towards EU level. The administered prices (prices regulatedby the Government), representing currently 21% of the CPIbasket, are in a rising trend in Romania as a result both ofa price convergence towards EU level, the price level inRomania being overall much below than in EU, and inorder to cover production costs. If the regulated priceswere free prices, then the regulated prices will increase evenmore, and consequently if we ignore these prices theBalassa–Samuelson effect would be underestimated. More-over, in the future the regulated prices would be free prices(market prices) and they could be considered as non-trad-able in the long-run. Therefore, the Balassa–Samuelsoneffect is expected to result into higher inflation with futureprice liberalization for non-tradables.

The econometric techniques used in the paper helped usdraw the conclusion that in the period 1998–2006 the aver-age annual rate of inflation generated by the Balassa–Sam-uelson effect in Romania was between 0.1% in 2005 and1.34% in 1999 in the case of the classical model. In theextended model, the impact on inflation is higher andranges between 0.44% in 2005 and 4.52% in 1999. On aver-age, the impact of the classical Balassa–Samuelson effect oninflation was 0.6% and 2.46% in the extended model. What-ever the model taken into consideration, in 2005 we can seea strong slowdown in the Balassa–Samuelson effect impacton inflation in Romania mainly due to the strong slow-down in the productivity growth in industry last year. Inthe first half of 2006, due to a new strong increase in pro-ductivity, the Balassa–Samuelson effect strengthens again.

Regarding the impact of the Balassa–Samuelson effecton the real appreciation of the exchange rate, the resultsof the paper revealed that the real appreciation of theexchange rate due to the Balassa–Samuelson effect wasbetween 0.19% and 2.55% (average of 0.9%) in the caseof the classical model and between 0.48% and 4.7% (aver-age of 2.36%) in the case of the extended model.

The relatively limited impact of the Balassa–Samuelsonin Romania could be explained by the low share of non-tradable (mainly services) prices. We think that the impact

of the Balassa–Samuelson effect on inflation in the futurewould be amplified due to the fact that the share of servicesin the CPI basket should increase.

Acknowledgements

The paper has benefited from discussion at seminars atthe Doctoral School of Finance and Banking (DOFIN,www.dofin.ase.ro) headed by Mr. Professor Moisa Altar.The authors would like to thank, without implicating them,to Moisa Altar, Nicolae Dardac, Dan Bucsa, Nicolae Alex-andru Chidesciuc, Nicolae Covrig and Ciprian Necula foruseful remarks and suggestions. The possible remainingerrors are entirely our responsibility.

Appendix. Theoretical Balassa–Samuelson model

According to Egert (2003) , we can write the productionfunction in these two sectors of the economy in a Cobb–Douglas functional form:

Y T ¼ AT � ðLTÞc � ðKTÞ1�c;

Y NT ¼ ANT � ðLNTÞd � ðKNTÞ1�d;

ð1Þ

where A: total factor productivity (TFP); L: labor force; K:capital; T and NT stands for tradable and non-tradablesectors.

The profit functions for the two sectors are

GT ¼ P T � Y T � R� KT � W � LT;

GNT ¼ P NT � Y NT � R� KNT � W � LNT;ð2Þ

where P: price level; G: profit level; R: interest rate; W:wage level.

Substituting relation (1) into relation (2), we obtain

GT ¼ P T � ðAT � ðLTÞc � ðKTÞ1�cÞ � R� KT � W � LT;

GNT ¼ P NT � ðANT � ðLNTÞd � ðKNTÞ1�dÞ � R� KNT

� W � LNT:

ð3Þ

Profit maximization implies that the marginal productof labor and capital will be equal with the wage and interestrate, respectively:

oGT

oLT¼ P T � AT � c� KT

LT

� �1�c

¼ W ;

oGNT

oLNT¼ P NT � ANT � d� KNT

LNT

� �1�d

¼ W ;

ð4aÞ

oGT

oKT¼ P T � AT � ð1� cÞ � LT

KT

� �c

¼ R;

oGNT

oKNT¼ P NT � ANT � ð1� dÞ � LNT

KNT

� �d

¼ R:

ð4bÞ

Dividing relation (4a) and (4b) with price level (P), weobtain

http://www.dofin.ase.ro


AT � c� KT

LT

� �1�c

¼ W

P T;

ANT � d� KNT

LNT

� �1�d

¼ W

P NT;

ð5aÞ

AT � ð1� cÞ � LT

KT

� �c

¼ R

P T;

ANT � ð1� dÞ � LNT

KNT

� �d

¼ RP NT

;

ð5bÞ

Taking log in relations (5a) and (5b) and normalizing pricesto tradable prices (PT = 1), we have (lower-case letters arevariables in logarithm):

w ¼ ln cþ aT þ ð1� cÞ � ðkT � lTÞ;

w ¼ pNT þ ln dþ aNT þ ð1� dÞ � ðkNT � lNTÞ;

r ¼ lnð1� cÞ þ aT � c� ðkT � lTÞ;

r ¼ pNT þ lnð1� dÞ þ aNT � d� ðkNT � lNTÞ:

ð6Þ

Applying the differential operator in relation (6), weobtain

DWW¼ Dc

cþ DAT

ATþ ð1� cÞ �

D KT

LT

� �KT

LT

;

DWW¼ DP NT

P NTþ Dd

dþ DANT

ANTþ ð1� dÞ �

D KNT

LNT

� �KNT

LNT

;

ð6aÞ

DRR¼ Dð1� cÞ

1� cþ DAT

AT� c�

D KT

LT

� �KT

LT

;

DRR¼ DP NT

P NTþ Dð1� dÞ

1� dþ DANT

ANT� d�

D KNT

LNT

� �KNT

LNT

:

ð6bÞ

With DR = 0 and Dc = Dd = D (1 � c) = D(1 � d) = 0, and

using notations w; p; a; m instead of DWW ; DP

P ;DAA ;

D KLð Þ

KL

, Eqs.(6a) and (6b) can be rewritten as

w ¼ aT þ ð1� cÞ � mT; ð7Þ

w ¼ pNT þ aNT þ ð1� dÞ � mNT; ð8Þ

aT ¼ c� mT; ð9Þ

aNT ¼ d� mNT � pNT: ð10Þ

Substituting Eq. (9) in Eq. (7), we obtain

w ¼ c� mT þ ð1� cÞ � mT ¼ mT: ð11ÞUsing (11) in Eq. (9) we obtain

w ¼ aT

c: ð12Þ

Substituting Eq. (10) in Eq. (8), we have

w ¼ pNT þ d� mNT � pNT þ ð1� dÞ � mNT ¼ mNT: ð13Þ

Eq. (13) is used in (8) and Eq. (12) is used in (14) leading to

w ¼ pNT þ aNT þ ð1� dÞ � w; ð14ÞaT

c¼ pNT þ aNT þ ð1� dÞ � aT

c; ð15Þ

pNT ¼ dc� aT � aNT: ð16Þ

Eq. (16) is the internal transmission mechanism of theBalassa–Samuelson effect, meaning the relationship be-tween the productivity differential and relative prices ofnon-tradable goods. In other words, Eq. (16) presents theimpact of productivity increases on inflation in non-trad-able sector. Assuming that d = c, in practice, Eq. (16) istested as following:

ðpNT � pTÞ ¼ f ðaT � aNTÞ: ð16aÞ

If all three hypotheses are valid and Eq. (16a) is valid alsofor the foreign country (the trading partner country), theincrease in productivity differential and the change in rela-tive prices should be related:

ðpNT � pTÞ � ðpNT� � pT�Þ ¼ ðaT � aNTÞ � ðaT� � aNT�Þ:ð17Þ

The headline inflation could be written as

p ¼ a� pT þ ð1� aÞ � pNT: ð18Þ

Substituting relation (18) in (16a) and (17), the inflationrate and inflation differential driven by the Balassa–Sam-uelson effect are

p ¼ pT þ ð1� aÞ � ðaT � aNTÞ; ð19Þp � p� ¼ ðpT � pT�Þ þ ½ð1� aÞ � ðaT � aNTÞ

� ð1� a�Þ � ðaT� � aNT�Þ�: ð20Þ

Applying the relation (18) on home and foreign country,we obtain

q ¼ eþ a� � pT� þ ð1� a�Þ � pNT� � ða� pT þ ð1� aÞ � pNTÞ;ð21aÞ

q ¼ eþ a� � pT� þ ð1� a�Þ � pNT� � a� pT � ð1� aÞ � pNT;

ð21bÞq ¼ eþ pT� � pT � ð1� a�Þ � pT�

þ ð1� a�Þ � pNT� þ ð1� aÞ� pT � ð1� aÞ � pNT

� ð1� a�Þ � pT� þ ð1� a�Þ � pNT�

¼ �ð1� a�ÞðpT� � pNT�Þ; ð21cÞð1� aÞ � pT � ð1� aÞ � pNT ¼ ð1� aÞðpT � pNTÞ: ð21dÞ

Using relation (21d) in the relation of the real exchangerate q = e + p* � p we obtain

q ¼ eþ pT� � pT þ ð1� aÞðpT � pNTÞ� ð1� a�ÞðpT� � pNT�Þ: ð22Þ


References

Balassa, B., 1964. The purchasing–power–parity doctrine: A reappraisal.Journal of Political Economy 72 (6), 584–596.

Begg, D., Halpern, L., Wyplosz, C., 1999. Monetary and Exchange RatePolicies, EMU and Central and Eastern Europe. Forum Report on theEconomic Policy Initiative; No. 5; CEPR; London.

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Egert, B., Drine, I., Lommatzsch, K., Rault, C., 2002. The Balassa–Samuelson effect in Central and Eastern Europe: Myth or reality?William Davidson Institute Working Paper No. 483.

Egert, B., 2003. Nominal and real convergence in Estonia: The Balassa–Samuelson (dis)connection. Oil shale, tradable goods, regulated prices andother culprits. William Davidson Institute Working Papers Series, 556.

Egert, B., 2005. Balassa–Samuelson meets South Eastern Europe, theCIS and Turkey: A close encounter of the third kind? William

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Knight, G., Johnson, L., 1997. Tradables. Developing Output and PriceMeasures for Australia’s Tradable and Non-tradable Sectors. ABSWorking Paper No. 97/1.

Kovacs, M.A., 2002. On the estimated size of the Balassa–Samuelsoneffect in five Central and Eastern European countries. Prepared by theCEC5 National Banks for the Basle meeting of March.

Samuelson, P., 1964. Theoretical notes on trade problems. Review ofEconomics and Statistics 2, 145–154.

Taylor, M.P., Sarno, L., 2001. Real exchange rate dynamics in transitioneconomies: a non-linear analysis. Studies in Non-Linear Dynamics andEconometrics, vol. 5, issue 3, article 1.

Tica, J., Druzic, I. 2006. The Harrod–Balassa–Samuelson Effect: A Surveyof Empirical Evidence. Faculty of Economics and Business, Universityof Zagreb, EFZG Working Papers Series No. 0607.

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The Balassa–Samuelson effect in Romania – The role of regulated prices