Productivity, Tradability, and the Long-Run Price Puzzle

Long-run cross-country price data exhibit a puzzle. Today, richer countries exhibit higherprice levels than poorer countries, a stylized fact usually attributed to the Balassa-Samuelson effect. But looking back fifty years, this effect virtually disappears from thedata. What is often assumed to be a universal property is actually quite specific to recenttimes, emerging a half century ago and growing steadily over time. What mightpotentially explain this historical pattern? We develop an updated Balassa-Samuelsonmodel inspired by recent developments in trade theory, where a continuum of goods aredifferentiated by productivity, and where tradability is endogenously determined. Firmsexperiencing productivity gains are more likely to become tradable and crowd out firmsnot experiencing productivity gains. As a result the usual Balassa-Samuelsonassumption?that productivity gains be concentrated in the traded goods sector?emergesendogenously, and the Balassa-Samuelson effect on relative price levels likewise evolvesgradually over time.