Another Prospective on Real Exchange Rate and the Traded Goods Prices: Revisiting Balassa–Samuelson Hypothesis

Abstract

This paper proposes a new variant and reinvestigates the validity of the Balassa–Samuelson (BS) hypothesis for nine East and South Asian countries under new specifications. The BS hypothesis is often criticized for one of its fundamental, but oversimplified assumptions related to Purchasing Power Parity (PPP) holding which can be confirmed for cronss-country tradables’ prices, implying nontraded-sector prices are solely responsible for inducing trend deviations in real exchange rate. The assumption, when empirically tested, does not always hold valid, revealing a price difference in tradables for Asian countries against the world (U.S.), a potential driver of their trend in real exchange rate deviations (appreciation). A new approach based on Fully Modified OLS (FMOLS) and Dynamic OLS (DOLS) is used to estimate the long-run BS coefficients, while the error correction mechanism is employed to estimate the short-run estimates. These results motivated us to allow for the inexistence of PPP for cross-country tradables; the standard form of the BS model is then tested in its relaxed form using time-series and panel data econometric tests. Despite a relaxing of the BS model in favor of tradables’ price deviation from PPP, the results are not sufficiently supportive of the BS hypothesis. These findings hold strong economic implications for Asia, suggesting that intercountry sectoral productivity bias of regional economies with the world does not necessarily exert substantial effects on their long-run real exchange rates. Additionally, contrary to the core belief of the BS model, intercountry tradables’ price differentials are found to substantially explain real exchange rate movements away from their long-run equilibrium.