Economic Structure, Welfare, and the Real Exchange Rate

Abstract

Transitioning or developing countries that are in the process of catching-up usually experience an increase in the productivity of the tradable goods sector. This often entails a subsequent increase in real wages, which may lead to higher wages in the non-trading sectors of the economy. If productivity in these sectors does not sufficiently increase, a country will experience rising inflation rates and an appreciation of their real exchange rate, which is known as the Balassa-Samuelson effect. Such a development can eventually hamper economic growth and welfare in a country and can also lead to a sudden stop and a serious crisis. In this paper, we first present a simple theoretical model inspired by Christopoulos et al. (2010) to highlight how structural changes in the economy that alter the sectoral structure of an economy and its wages and welfare level impact the real exchange rate. We will also provide empirical evidence for the case study in Latvia.