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A Small Open Economy with the Balassa-Samuelson Effect

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  • Robert Ambrisko

Abstract

The Balassa-Samuelson (B-S) effect implies that highly productive countries have higher inflation and appreciating real exchange rates because of larger productivity growth differentials between tradable and nontradable sectors relative to advanced economies. The B-S effect might pose a threat to converging European countries, which would like to adopt the Euro because of the limits imposed on inflation and nominal exchange rate movements by the Maastricht criteria. The main goal of this paper is to judge whether the B-S effect is a relevant issue for the Czech Republic to comply with selected Maastricht criteria before adopting the Euro. For this purpose, a two-sector DSGE model of a small open economy is built and estimated using Bayesian techniques. The simulations from the model suggest that the B-S effect is not an issue for the Czech Republic when meeting the inflation and nominal exchange rate criteria. The costs of early adoption of the Euro are not large in terms of additional inflation pressures, which materialize mainly after the adoption of the single currency. Also, nominal exchange rate appreciation, driven by the B-S effect, does not breach the limit imposed by the ERM II mechanism.

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  • Robert Ambrisko, 2015. "A Small Open Economy with the Balassa-Samuelson Effect," CERGE-EI Working Papers wp547, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    • Handle: RePEc:cer:papers:wp547
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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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