Balassa- Samuelson effect in Iran

The gap productivity in tradable goods between two countries is a factor of fluctuations real exchange rate and it is called Balassa–Samuelson effect (1964). The BS (Balassa–Samuelson effect) idea originates from inflation gap between the U.S.A. and Japan in the 1960s and the attempts for understanding how much of the inflation gap between U.S. and Japan was due to the productivity gap between tradable goods in two countries. If total factor productivity in tradable goods in country A is more than country B, value of the national currency and deviation of Purchasing Power Parity (PPP) will increase in country A.
This effect explains why the non-tradable price of goods in countries with a lower productivity is less than other countries. This difference of price makes a deviation of PPP. For example, annual average inflation rate during 1955-1970 in Japan was 5.4 percent. In the same period, annual average inflation rate in the U.S.A. was 2.6 percent. The gap of inflation rate between Japan and the U.S.A. had been 2.8 percent (Imai, 2010); consequently, the value of Japanese currency increased, too. When we assume that there are two goods in the economy, namely, tradable and non-tradable goods, then, labor is a factor of production. If productivity of tradable goods in Japan is more than the U.S.A., then the price of tradable goods in Japan should be less than the U.S.A., but it is not true because tradable goods are traded between countries and have a unit price in all countries. Based on profit maximization condition that is , when increases and is not changed in tradable sector, then, of tradable and non-tradable sectors will increase, because labor is mobile between tradable and non-tradable sectors. The result is the increasing price of non-tradable goods in Japan while the non-tradable price in the U.S.A. is constant. This difference in the price of non-tradable sector between Japan and the U.S.A. is explained deviation of PPP in Japan.
In this paper we estimated BS effect in Iran. Total factor productivity in Iran is less than the U.S.A., then, part of deviation PPP in Iran is the productivity gap between Iran and the partner’s countries with which Iran trades.
Literature Review of Balassa–Samuelson Effect
We assume two countries 1 and 2, two sectors tradable and non-tradable and define the following notation: Productivity of non-tradable goods in country 1.
Productivity of non-tradable goods in country 2.
Wage rate in country 1.
Wage rate in country 2.
And : price of non-tradable goods in 1 and 2 countries.
And : price of tradable goods in 1 and 2 countries.
Assumptions: 1. Same productivity in two countries and equality to unit:
2. Labor is full mobility between tradable and non-tradable goods within country.
3. Unit Price Law in tradable sector: Now we can write for country 1:
And for country 2: Then
Divided Eq.6 to Eq.7
Now if , then , and it is BS effect. In other words, higher non-tradable price in country 1 is due to higher productivity in tradable goods in country 1. This is one of the causes of PPP deviations. When productivity in tradable sector increases, wage is increased and labor will move to tradable sector. Then non-tradable wage increases up to equilibrium in two sectors. In this situation, price of non-tradable goods increases and we have deviation of PPP (Hamano 2012).
According to Purchasing Power Party (PPP), Law of Unit Price, and assuming no transportation costs for tradable goods, the price of them in all countries is same, but non-tradable goods have a different price in other countries. The Balassa–Samuelson indicated that the different price of non-tradable goods is due to the productivity difference in tradable goods between two countries. Then, a part of inflation gap or deviation of PPP (condition of fixed exchange rate) is due to the productivity gap of tradable goods in two countries. Note that the inflation gap between two countries is due to several factors and one of them is Balassa–Samuelson Effect.
This paper estimated BS effect in Iran with comparing inflation rate of Iran and the U.S.A. during 2002-2011, and the nominal exchange rate (Rials/ U.S. $) is fixed. According to Emai (2010), the gap of inflation rate between two countries is the decomposition of productivity gap of tradable and non-tradable goods in two countries, and then we estimate BS effect. We assumed that the industrial and service sectors are a proxy for tradable and non-tradable sectors. The result shows that, BS effect in Iranian economies had been -2.1 percent during 2002-2011. This means that, the real devaluation of Iranian Rials as a 2.1 percent during 2002-2011 is reasonable, while in fact, Iranian economies show that, both real devaluation of Iranian Rial and Iranian Rial against U.S.'s $ real appreciation during 2002-2011 was about 13.6 percent (annual average gap inflation rate between Iran and U.S.). In other word, when annual average inflation rate of U.S. at the same time was 2.2 percent and BS effect was -2.1 percent, the annual average inflation rate of Iran was 0.1 percent which is considered reasonable in the same period of time.
The final result of this paper is that high inflation rate in Iran (the deviation of PPP in Iran) is not due to the productivity gap between Iran and other countries such as the U.S.