Modelling the Balassa-Samuelson Effect in Australia

This paper examines the Balassa-Samuelson hypothesis in Australia using the ARDL cointegration framework. Evidence was found of a significant long-run relationship between real exchange rate and Australia-US productivity differential during the period of 1950-2003. The results indicate that a one per cent increase in labour productivity in Australia relative to the US will lead to 5.6 per cent appreciation in the real exchange rate of Australia. The estimated coefficient for the error correction term is -0.1983 and is highly significant, indicating that the deviation from the long term real exchange rate equilibrium path is corrected by nearly 20 per cent over the following year. The Author suspects that the elasticity coefficient is “over-estimated” due to the exclusion of relevant explanatory variables in the analytical model. The real exchange rate movements are affected by real fundamentals and policy-induced shifts in its real fundamentals. The fundamentals include the terms of trade, government expenditure, real interest rate differentials, net foreign liabilities among others along with labour productivity differential.