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      Question

      The Balassa-Samuelson effect provides a structural

      explanation for PPP deviations. It predicts that:
      A Countries with higher productivity growth in the tradeable sector will have relatively higher price levels and appreciated real exchange rates, causing systematic PPP deviations Correct Answer Incorrect Answer
      B Countries with higher productivity in the non-tradeable sector will have lower price levels than PPP would predict Correct Answer Incorrect Answer
      C PPP holds precisely for tradeable goods but fails for all goods equally across developed and developing countries Correct Answer Incorrect Answer
      D Higher inflation in a country always causes real exchange rate depreciation, confirming PPP in relative terms Correct Answer Incorrect Answer

      Solution

      Mechanism: Productivity growth in tradeables raises wages in that sector. Since labour is mobile domestically, wages also rise in non-tradeables — without a corresponding productivity increase. Non-tradeable prices therefore rise. Richer, more productive countries have higher overall price levels than PPP predicts — their real exchange rate appears appreciated. This explains why PPP deviations are systematically related to income levels (Penn effect), not random noise. Richer countries consistently appear “more expensive” in international comparisons.

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