Exam 16: Price Levels and the Exchange Rate in the Long Run

Correct Answer:

Verified

When comparing price levels across countries, a striking empirical regularity stands out. The absolute price level among countries is positively correlated with the level of real GDP per capita. In other words, as real GDP per capita rises, so does the price level. This also means that the overall cost of living is lower in poor countries than it is in wealthier countries. For instance, the cost of living in Mexico is lower than it is in the U.S. There are two general explanations of this phenomenon. First, Bela Balassa and Paul Samuelson both formulated an explanation along the following lines. The first part of the explanation is that labor, on average, is less productive in poor countries than it is in wealthy countries. However, there is a productivity difference in poor countries between tradable goods and nontradable goods. Balassa and Samuelson posit that in tradeable goods, workers in wealthy countries are much more productive than workers in poor countries. For nontradable goods, the differences in productivity between workers in wealthy or poor countries may be negligible. The key is that labor may shift between the two sectors in the long run. This means that wages in one sector influence wages in the other sector. In the tradeable goods sector, workers in the wealthy countries earn high wages because their productivity is high. Since workers may shift from one sector to the other, high wages in the tradeable goods sectors pushes up wages for workers in the nontradable sector. Across countries there may not be very much difference in workers' productivity in the nontradable sector. Nontradables are really cheaper in poor countries because workers are paid less per unit of output than they are in rich countries. This makes the prices of nontradables relatively more expensive in wealthy countries than in poor countries. As nontradables are a substantial component of almost any country's price index, prices overall will tend to be higher in wealthy countries than in poor countries. Jagdish Bhagwati, Irving Kravis, and Robert Lipsey developed the second explanation of the difference in national wage levels. The central point of their argument is that wealthy countries have a higher endowment of capital. On average, tradeable goods are probably more capital intensive than nontradable goods. The greater endowment of capital in wealthy countries means that workers in tradeable goods in these countries will be relatively more productive and earn higher wages. Nontradables usually are more labor intensive. Since poor countries tend to have an abundance of labor, their nontradables will be less expensive. The two explanations complement one another. In any case there are sound economic reasons why the overall price level should be different between wealthy and poor countries.