Looking for the Balassa-Samuelson effect in real exchange rate changes

Abstract

Using the MSE decomposition technique, Engel (1999) found that real exchange rate changes between the US and the UK are accounted for mainly by tradables price changes. He reported that no Balassa-Samuelson effect in real exchange rate changes is detected in real data. However, we argue that Engel’s findings are because the US and the UK do not have large enough sectoral productivity differentials as the Balassa-Samuelson effect requires. Using the monthly data from January 1985 through February 2007 for a country pair of the US and Korea as well as from January 1980 through February 2007 for another country pair of the US and Japan, we measured and compared the MSE shares of non-tradables price changes in real exchange rate changes. We found a clear difference in the movements of non-tradables price changes between the two pairs: the MSE shares of non-tradables price changes in the real exchange rate changes between the US and Korea were two times greater than those between the US and Japan from January 1985 through September 1995 when Korea experienced more rapid growths in the tradable sector than in the non-tradable sector in comparison with between the US and Japan.