A model of relative national price levels under pricing to market

Abstract

This paper proposes an alternative to the Balassa–Samuelson theory of how relative price levels between countries are determined. The theory is a general equilibrium formulation of a model where pricing to market arises endogenously from firm decisions. It differs from Balassa–Samuelson in that it centers on the distinction between segmented national goods markets rather than the distinction between traded and nontraded goods. The paper also explores how Balassa–Samuelson might be updated by combining it together with pricing to market elements. Applied to the case of a monetary union, the theory offers an alternative explanation for the inflation differentials observed in EMU. It implies that such differentials may be a natural and enduring feature of a monetary union in which markets for goods and labor are less than fully integrated.