The Balassa-Samuelson and the Penn Effect: Are They Really the Same?

According to the Balassa-Samuelson e¤ect, productivity gains in the domestic tradable sectorraise the relative price of domestic non-tradables causing deviations from the purchasing powerparity. In the literature, the Balassa-Samuelson e¤ect is typically invoked to explain the Penne¤ect, according to which the price level is higher in richer countries, so that their real income isoverstated if converted at market exchange rates. In this paper, using a two-country, two-sectorinternational real business cycle model, which closely follows Stockman and Tesar (1995) andBenigno and Thoenissen (2008), we show that the Balassa-Samuelson e¤ect only explains thePenn e¤ect either for a su¢ ciently high trade elasticity or for a low degree of home bias; if assetmarkets are incomplete, furthermore, it does so also in the presence of high complementaritybetween tradables and non-tradables or for a low share of tradables in consumption. Theseresults are coherent with the empirical evidence, which generally supports the prediction of theBalassa-Samuelson model about relative price of non-tradables but is more controversial aboutreal exchange rate appreciation in response to productivity gains in tradables.[...]