Purchasing Power Parity, Wages and Inflation in Emerging Markets

Three open economy puzzles are, first, the price level of an advanced economy (AE) is higher compared to that of an emerging or developing economy (EDE) measured in the same currency. But, second, inflation tends to be much higher in EDEs. Third, there is a persistent deviation of real exchange rates from equilibrium values although nominal shocks, which cause such deviation, are expected to have only short-run effects. Balassa Samuelson (BS) explained the first puzzle by introducing two sectors with differential productivity growth. The article presents a framework that allows a new simple proof of the BS result. Inflation in EDEs is often attributed to the catch-up process where productivity in traded goods starts growing faster than that in non-traded goods. But if wages grow at a relatively higher non-traded goods productivity growth, nominal shocks can trigger deviations from equilibrium and adjustments that sustain inflation. This explanation retains the BS ranking of relatively lower traded goods productivity in EDEs, yet explains the second and third puzzles. Tests with Indian data support the hypotheses, suggesting that they provide a better explanation of Indian inflation.