Wealth, Price Levels and Product Quality
27 Pages Posted: 19 Sep 2019 Last revised: 9 Oct 2019
Date Written: June 28, 2019
Why are price levels in Germany lower than in Switzerland despite comparable productivity levels in these two regions? Standard models in macroeconomics have severe difficulties in explaining this theoretically important outlier as they emphasize cross-country productivity differences in tradable goods as the sole source of price level variations across countries. We construct a dataset of 73 developed and developing countries to highlight the tight connection between price levels, product quality and household wealth. We then provide a theory linking these three forces. Wealth induces consumption shifts toward more expensive goods. As official price statistics tend to underestimate quality improvements, they overstate prices. In turn, higher product quality that comes with higher wealth inflates prices and thus contributes toward explaining price level differences across countries.
Keywords: Engel’s Law, Product Quality and Varieties, Structural Change, Growth, Trade, Price Levels
JEL Classification: E23, E24, F11, F31, O41
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