The Rich Neighborhood Effect Model vs. the Balassa-Samuelson Model: A General Theory of National Price Levels

Abstract

As a standard explanation for national price levels, the Balassa-Samuelson (BS) model presupposes a homogeneous domestic labor force and intersectoral labor mobility. We propose a contrasting theory of the “rich neighborhood effect” (RNE). It is a more general theory because it explicitly allows for domestic labor force heterogeneity and because it is formulated as a coherent supply-demand framework that incorporates demand-side factors such as the Linder effect. We also develop a contemporary RNE model that predicts different behavior of the price level between high-income and low-income countries, which is confirmed by the empirical data. Specifically, we show that for high-income countries the unskilled proportion of the labor force has a significant negative impact on the price level over and above its indirect effects through income, which is not the case for low-income countries. These results are compelling evidence in favor of the RNE model over the BS model.

Keywords: Balassa-Samuelson, real exchange rates, nontradables prices

JEL Classification: F31; F41