Real Exchange Rates In Developing Countries: Are Balassa-Samuelson Effects Present?

Transcription

1 WP/04/88 Real Exchange Raes In Developng Counres: Are Balassa-Samuelson Effecs Presen? Ehsan U. Choudhr and Mohsn S. Khan

2 2004 Inernaonal Moneary Fund WP/04/88 IMF Workng Paper Mddle Eas and Cenral Asa Deparmen Real Exchange Raes In Developng Counres: Are Balassa-Samuelson Effecs Presen? Prepared by Ehsan U. Choudhr and Mohsn S. Khan Ocober 2004 Absrac hs Workng Paper should no be repored as represenng he vews of he IMF. he vews expressed n hs Workng Paper are hose of he auhor(s) and do no necessarly represen hose of he IMF or IMF polcy. Workng Papers descrbe research n progress by he auhor(s) and are publshed o elc commens and o furher debae. here s lle emprcal research on wheher Balassa-Samuelson effecs can explan he longrun behavor of real exchange raes n developng counres. hs paper presens new evdence on hs ssue based on a panel daa sample of 6 developng counres. he paper fnds ha he raded-nonraded producvy dfferenal s a sgnfcan deermnan of he relave prce of nonraded goods, and he relave prce n urn exers a sgnfcan effec on he real exchange rae. he erms of rade also nfluence he real exchange rae. hese resuls provde srong verfcaon of Balassa-Samuelson effecs for developng counres JEL Classfcaon umbers: F3, F4 Keywords: Real exchange raes, Balassa-Samuelson effecs, developng counres Auhor(s) E-MalAddress: echoudhr@connec.carleon.ca, mkhan@mf.org Ehsan Choudhr s Chancellor s Professor a Carlon Unversy n Canada. he auhors would lke o hank Aasm Husan, Jean Le Dem, Gene Leon, Gan Mara Mles-Ferre, kunde Mwase, Sam Oulars, and Mguel Savasano for helpful commens and suggesons, and ala Kharabl for excellen research asssance.

3 - 2 - Conens Page I. Inroducon...3 II. III. IV. heorecal Framework...4 Emprcal Implemenaon...9 Resuls... V. Conclusons...7 ables. Un Roo ess he Exchange Rae Relaon: he Dversfcaon Case he Exchange Rae Relaon: he Specalzaon Case he Relave Prce Relaon... 5 Appendces. Poenal Bases Due o Measuremen Problems Daa Appendx... 9 References... 2

4 - 3 - I. IRODUCIO he well-known analyss of Balassa (964) and Samuelson (964) provdes an appealng explanaon of he long-run behavor of he real exchange rae n erms of he producvy performance of raded relave o nonraded goods. Bascally, he argumen s ha as he producvy of raded goods rses relave o ha of nonraded goods, here wll be a endency for he real exchange rae o apprecae. Balassa-Samuelson effecs are generally hough o be he key source of observed cross-seconal dfferences n real exchange raes (.e., he same-currency prces of comparable commody baskes) beween counres a dfferen levels of ncome per capa. 2 here s consderable emprcal research on Balassa-Samuelson effecs based on me-seres daa, bu hs research has been confned o ndusral counres. 3 he me-seres evdence on he workng of he Balassa-Samuelson mechansm for developng counres has been largely unexplored. 4 One reason for hs neglec s ha secoral prce and producvy daa are no readly avalable for developng counres. o address hs problem, hs paper makes use of recenly avalable daa from a number of sources o assemble a suable daa se for developng counres, whch s hen ulzed o oban new me-seres evdence on he operaon of Balassa-Samuelson effecs n hese counres. Balassa-Samuelson effecs can be embedded n a varey of models. hese effecs are ypcally derved whn a sac model, bu hey can be easly ncorporaed n he dynamc framework of he new open economy macroeconomc models. 5 Usng a framework compable wh he new open economy macroeconomc approach, hs paper derves wo seady-sae relaons ha capure key channels of he Balassa-Samuelson mechansm. he frs relaon lnks he real exchange rae o relave prces of nonraded goods a home and abroad. he basc verson of hs relaon s based on he assumpon ha all raded goods are 2 For a revew of he evdence and a dscusson of alernave explanaons, see Edwards and Savasano (999). See also Bergn, Glck, and aylor (2004), who pon ou ha alhough recen daa reveal srong assocaon beween naonal prce levels and ncome per capa, hs assocaon dsappears n hsorcal daa gong back ffy years or more. 3 See, for example, Canzoner, Cumby, and Dba (999), and Lane and Mles-Ferre (2002). 4 See, however, Io, Isard, and Symansky (997) who use me-seres daa o explore he Balassa-Samuelson hypohess for APEC economes ha nclude some developng counres. 5 hese models end o focus on he shor- o medum-erm dynamcs arsng from nomnal rgdes and have no pad much aenon o long-run Balassa-Samuelson nfluences. Bengno and heonssen (2002), however, do use a new open economy macroeconomc model o explore he effec of a producvy mprovemen n he raded good secor on he Uned Kngdom real exchange rae.

5 - 4 - produced n boh home and foregn counres. We also consder an alernave verson, whch assumes ha each counry specalzes n he producon of a dfferen raded good. hs varan of he relaon hen ncludes he erms of rade as an addonal deermnan of he real exchange rae. In boh versons, he law of one prce holds for each raded good n he long run. 6 he second relaon explans he relave prce of nonraded goods. Followng Canzoner, Cumby, and Dba (999), we use resrcons on producon echnology o derve a smple form of he relaon, whch makes he labor producvy dfferenal beween raded and nonraded goods he man deermnan of he relave prce of nonraded goods. 7 he echnology resrcon used o oban he second relaon s no needed o derve he frs relaon. For hs sudy, we assembled a daa se ha ncludes me-seres daa for abou wo decades for 6 developng counres. As ndvdual me seres are no very long, we pool hese seres across counres o esmae our relaons. Recen panel-daa economerc echnques are used o denfy long-run effecs n hese relaons. he resuls provde srong evdence ha he Balassa-Samuelson mechansm operaes n developng counres. Usng he Uned Saes as he reference counry, we fnd ha he U.S.-developng counry dfferences n he relave prce of nonraded goods and he erms of rade are sgnfcan deermnans of he real exchange rae n he long run. he dfferences n he labor producvy dfferenal, moreover, exer a sgnfcan long-run effec on he relave prce dfferences. One puzzlng resul s ha he esmaed effec of he relave prce varable s greaer and ha of he labor producvy varables smaller han he predced value. We sugges explanaons based on daa problems o accoun for hese dscrepances beween esmaed and predced values. he heorecal framework s oulned n Secon II. he daa and he emprcal model are dscussed n Secon III. Secon IV presens he resuls, and Secon V provdes some conclusons. II. HEOREICAL FRAMEWORK hs secon oulnes a framework o provde heorecal underpnnngs for our emprcal analyss. As we are concerned wh long-erm effecs, we do no model shor-run dynamcs, bu focus on seady-sae relaons under complee adjusmen of wages and prces. We consder a mul-counry framework wh each counry usng fxed endowmens of labor and 6 he real exchange rae for he raded-goods baske, however, need no be saonary f weghs for ndvdual raded goods dffer beween he home and foregn counres. Our emprcal procedure accouns for hs possbly. 7 An alernave approach would relae he relave prce o he oal facor producvy dfferenal. Demand-sde facors would also nfluence he relave prce n such a relaon.

6 - 5 - capal o produce raded and nonraded goods under perfec compeon. 8 We use wo specal models of he paern of raded-goods producon. he frs model follows he sandard Balassa-Samuelson formulaon and assumes ha each counry s dversfed and produces all raded goods. he second model assumes ha each counry s specalzed n he producon of a counry-specfc raded good, as n he Armngon (969) model. We dscuss below only he par of he model ha s needed o derve he relaons used n our emprcal analyss. Basc Seup Households n counry supply a fxed amoun of labor and maxmze he followng expeced lfeme uly: τ E δ U ( C ), where δ s he dscoun rae, and consumpon ndex s defned as: τ = τ C τ represens a consumpon ndex for perod τ. he C γ γ γ γ = ( C ) ( C ) /( γ ( γ ) ), () where C and C are he sub-ndexes for consumpon bundles of raded and nonraded goods, γ s he share of raded goods n aggregae consumpon, and me subscrps are dropped for smplcy. he raded goods baske s assumed o be he followng CES ndex of m (> ) goods: m σ /( σ ) j / σ j / σ [ ( ν ) ( C ) ] C =, (2) j= j j where C s he amoun consumed of raded good j, ν represens he wegh placed on he good, and σ (> ) s he elascy of subsuon beween raded goods. Le P denoe he consumer prce ndex, and P and P he prce ndexes for raded and nonraded goods. Usng () and (2), we defne P and P as he cos-mnmzng prces of C and C, whch are gven by: P = γ γ ( P ) ( P ), (3) m /( σ ) j j σ [ ν ( P ) ] P =. (4) j= 8 Our framework can be readly exended o ncorporae monopolsc compeon. As such an exenson would make lle dfference o he long-run relaons derved n he paper, we assume perfec compeon for smplcy.

7 - 6 - he paern of producon for raded goods s characerzed by eher dversfcaon (wh each counry producng all raded goods) or specalzaon (wh each counry producng a dfferen raded good). In he case of specalzaon, he number of counres equals he number of raded goods. For hs case, use he same ndex for raded goods and counres so j ha good s produced by counry. Leng Y and Y denoe oupus of he nonraded and j h raded good, we assume he followng Cobb-Douglas producon funcon for hese goods: 9 Y α β = A ( K ) ( L ), (5) Y j = A j ( K j α j ) ( L j ) β j j =,..., m f dversfed j = f specalzed, (6) where K and L represen he amouns of capal and labor used n he producon of he nonraded good, whle K and L are he correspondng amouns for he raded good j. j j Le counry be he reference counry, and defne S as he exchange rae of counry (expressed as he prce of counry s currency) wh respec o counry. We dsngush beween he shor and he long run n he presen model. he shor run s characerzed by nomnal rgdes n he form of scky wages and prces. he long run, on he oher hand, represens seady-sae equlbrum wh full adjusmen of wages and prces. In he shor run, nomnal rgdes can cause deparures from he law of one prce and he margnal producvy condon for labor. We assume below ha here are no deparures from hese relaons n seady sae. We focus on he seady-sae behavor of varables o derve Balassa-Samuelson effecs. Use a lde over a varable o denoe he seady-sae value of he varable. Assumng ha he law of one prce holds n seady sae, we can lnk seady-sae prces of raded goods n dfferen counres as follows: ~ ~ j j S P P ~ =. (7) Also, assume ha he margnal producvy condon s sasfed n seady sae. hus, leng W denoe he wage rae, and usng (5) and (6), we have: 9 he Cobb-Douglas form of he producon funcon s used below o derve a smple relaon beween he relave prce of nonraded goods and he labor producvy dfferenal. Canzoner, Cumby, and Dba (999) dscuss more general producon condons, whch would also mply such a relaon.

8 - 7 - ~ W ~ ~ ~ ~ = β ( Y / L ) P = β ( Y j j ~ / L j ~ ) P j j =,..., m f dversfed j = f specalzed. (8) Key Relaons We now derve key relaons n he log-lnear form. Use lower case leers o denoe values n logs, and defne he consumpon-based real exchange rae as: q = s + p. (9) p he prce of he nonraded good relave o he prce of domescally produced raded good(s) plays an mporan role n he deermnaon of he real exchange rae. Defne hs relave prce n logs as: = p p f dversfed rp. (0) = p p f specalzed o lnk q and rp, we use (4) and ake a log-lnear approxmaon of seady-sae radedgoods prce ndex around s nal value o ge: ~ m j j p = = θ ~ p, () j j where θ s he share of raded good j n oal raded-goods consumpon n he nal seady sae, and he nal seady-sae value of p~ s normalzed o equal zero. 0 In he case of specalzaon, nong ha only good s expored by counry, we can express () as: ~ p = θ ~ p + ( θ ) ~ p, (2) X X X M where ~ p = ~ p and ~ M = j j p θ ~ p /( θ ) are he prce ndexes for expors and X X j mpors, and θ = θ s now he (nal-seady-sae) share of he expor good n oal expendure on raded goods. 0 j j σ j j he share equals ν ( P ) / j = v ( P ) he nal seady sae. m σ, where j P s he prce of raded good j n

9 - 8 - For he dversfcaon case, use (3), (7), and (9)-() o oban: q ~ = ) ~ p + ( γ ) rp ~ ( γ ) r~ p =,. (3) m j j ( θ j θ j he frs erm on he rgh hand sde of (3) represens he log real exchange rae for raded goods n seady sae, q ~ (= ~ s + ~ p ~ p ). hs erm wll no equal zero and may exhb nonsaonary behavor f he composon of a counry s raded goods baske dffers from ha of he reference counry. he Balassa-Samuelson analyss s ofen smplfed by he ~ j ~ j assumpon ha expendure shares are he same everywhere. In hs smple case, θ = θ for all j, γ = γ, and (3) can be expressed smply as q~ ( )( ~ ~ = γ rp rp ). In he case of specalzaon, he erms of rade also nfluence he real exchange rae. Leng X M = p p denoe he log erms of rade, and usng (3), (7), and (9)-(2), we oban he relaon for he specalzaon case as: q ~ ~ m j j j = ( ) p ( ) rp ( ) rp j = θ θ + γ γ X ~ X ~, + ( θ )( γ ) ( θ )( γ ) ~ ~. (4) he frs erm on he rgh hand sde of (4) sll equals q ~. oe ha r ~ p now represens he relave (seady-sae) prce of he nonraded good n erms of domescally-produced raded good. he erms of rade hus ener he relaon because hey affec he prce of he raded goods baske relave o ha of he raded good produced a home. ex, he relave prce of nonraded goods can be relaed o he producvy dfferenal beween domescally produced raded and nonraded goods. Defne he log labor producvy n he wo secors as: lp j j j = ω y l f dversfed j ( ), = y l f specalzed (5) lp = y l. (6) j For he dversfcaon case, ω s he wegh for good j s labor producvy n he aggregae labor producvy ndex for raded goods. Le lp = lp lp denoe he labor producvy dfferenal beween raded and nonraded goods. In defnng he dversfcaon labor producvy ndex n seady sae, we use he same weghs as hose n he raded-goods prce j j ndex. Usng (8), (5), and (6), and leng ω = θ for he dversfcaon case, we can express he seady-sae relave prce as: r ~ p = ϑ + l~, (7) p m j where ϑ equals j = θ logβ j log β n he case of dversfcaon, and log β log β n he case of specalzaon.

10 - 9 - III. EMPIRICAL IMPLEMEAIO Daa We use a number of sources o pu ogeher a developng economes panel daa se ha ncludes me seres from 976 o 994 for 6 counres. hs se ncludes 4 counres a low- and medum-ncome levels and 2 hgh-ncome economes (Republc of Korea and Sngapore) ha had lower ncome levels a he begnnng of he sample perod. raded goods are assumed o conss of manufacurng and agrculure secors. onraded goods are represened by all oher secors. he Uned Saes s chosen as he reference counry. he real exchange rae s based on consumer prce ndexes and represens he real value of a currency n erms of U.S. dollars. Alhough our classfcaon of he raded and nonraded goods secors s smlar o he one used for ndusral counres, one poenal problem s ha a subsanal poron of he agrculure secor (and possbly of he manufacurng secor) n developng counres may conss of radonal acves producng nonraded goods. Anoher problem s ha he qualy of labor s lkely o vary consderably n developng counres, and our labor producvy measure (based on employmen fgures unadjused for qualy changes) does no accoun for hs varaon. 2 We are unable o address hese ssues because of daa lmaons. However, we explore below ceran mplcaons of hese measuremen problems for he esmaon of he emprcal model. Emprcal Model o underake panel-daa ess of he Balassa-Samuelson relaons, we assume ha long-run parameers (based on seady-sae expendure shares) are he same across our developng counry se (D). 3 X X hus, we se θ = θ and γ = γ for D. However, o allow for possble developng-ndusral counry dfferences n expendure shares, we do no requre U.S. (counry ) parameers o be he same as he ones for our developng-counry sample. Deals of he varables and daa sources are provded n Appendx II. 2 As noed n Appendx II, anoher lmaon of he daa on labor npus s ha employmen measures for he manufacurng, agrculure, and oher (nonraded goods) secors come from dfferen sources, and are no fully comparable. Also, noe ha labor producvy for raded goods s smply measured as he rao of oal oupu o oal employmen n he raded goods secor. For he dversfcaon case, hs ndex does no fully conform o he heorecal ndex used n (7), snce he mplc weghs for ndvdual raded goods n hs ndex could dffer from he weghs used n he raded-goods prce ndex. 3 We laer allow hese parameers o vary beween developng counres a dfferen ncome levels.

11 - 0 - he followng wo equaons are esmaed o es for Balassa-Samuelson effecs: q = µ + κ + π rpd + τ d + u, (8) rpd = ψ + χ + λ lpd + v, D, (9) where rpd = rp rp, d =, and lpd = lp lp are, respecvely, he dfferences n he relave prce of nonraded goods, he erms of rade, and he radednonraded producvy dfferenal beween developng counry and he Uned Saes; µ and ψ are counry-specfc fxed effecs whle κ and χ are common me effecs; and u and v are error erms. me effecs represen he nfluence of common me-specfc (shor- and long-run) facors, and error erms capure he effecs of shor-erm devaons from seady sae (ha are no ncluded n me effecs). Equaon (8) s derved from (3) and (4), and ness he dversfcaon and specalzaon cases. Dversfcaon mples ha τ = 0 whle specalzaon mples ha X τ = ( θ )( γ ) > 0. In boh cases, π = ( γ ) > 0. Equaon (9) s based on (7). In hs equaon, λ =. he absence of Balassa-Samuelson effecs would mply ha π = τ = λ = 0. 4 oe ha me effecs n (8) would pck up long-run movemens n he real exchange rae for raded goods arsng from paramerc dfferences beween developng counres and he Uned Saes. Alhough he long-run parameers n (8) and (9), π, τ, and λ, are consraned o be he same across developng counres, hese relaons allow he shor-run dynamcs (refleced n he me seres behavor of he error erms) o be dfferen across counres. he explanaory varables, rpd, d, and lpd, can be saonary, rend-saonary or nonsaonary. In he case of rend-saonary behavor, (8) and (9) can be modfed o nclude a me rend. Coeffcens of me rends n he wo relaons would be homogeneous across counres, and depend on he long-run parameers. 5 oe ha f explanaory varables are negraed or rend-saonary, hen q would also be negraed or rend-saonary. In hs case, Balassa- Samuelson effecs would cause permanen deparures from he purchasng power pary. 4 ess of Balassa-Samuelson effecs could also be based on alernave versons of (8) and (9), whch exclude U.S. varables, rp,, and lp, and are expressed as q = µ + κ + π rp + τ + u, and rp = ψ + χ + λ lp + v. However, we esmae relaons n he form ha ncludes U.S. varables because hs form allows us o explore wheher U.S. varables exer an effec addonal o her effec va rpd, d, and lpd. 5 Leng rpd = g + rpd, d = g 2 + d, and lpd = g 3 + lpd, we can resae (8) and (9) as follows: q = µ + κ + ( g + g + rpd + d π 2τ ) π τ + u, and rpd = ψ + χ + g λ + λ lpd 3 + v.

12 - - As dscussed above, our measure for he raded goods secor (.e., agrculure plus manufacurng) may be oo broad for developng counres and could nclude nonraded goods. As dscussed n Appendx I, he measured relave prce of nonraded goods n hs case would undersae he rue relave prce, and bas he relave-prce coeffcen upward n (8). hs measuremen problem would no lead o a sysemac bas n he esmaon of (9), snce he measured value of he raded-nonraded producvy dfferenal would also undersae s rue value. A more serous problem for esmang (9) s ha he labor producvy measure s no adjused for qualy varaon. Appendx I shows ha he esmaed effec of measured labor producvy dfferenal would be based downward f here s a posve assocaon beween he average labor qualy and he rue labor producvy. Esmaon IV. RESULS Before esmang (8) and (9), we examne wheher he varables n hese relaons conan a un roo or no. able shows he resuls of wo ess of a un roo n panel daa. In he frs es (LL) based on Levn and Ln (993), he null hypohess of a un roo s esed agans he alernave of a homogeneous auoregressve coeffcen. he second es (IPS) due o Im, Pesaran, and Shn (2003) ess he un roo null agans a more general alernave of a heerogeneous auoregressve coeffcen. Boh ess ndcae ha q conans a un roo (wh or whou a me rend). 6 For he remanng varables, he ess are sensve o wheher a me rend s ncluded or no. In he absence of a rend, he un roo hypohess s no rejeced for rpd and d by boh he LL and IPS ess, and for lpd by he LL es. However, f a rend s presen, boh ess ndcae ha rpd and lpd are no negraed, and IPS es ndcaes ha d s also no negraed. We frs consder he basc form of (8) and (9), whch does no nclude a me rend. In hs case, snce here s ndcaon of nonsaonary behavor for varables n hese relaons, we also underake ess for conegraon. We use wo paramerc ess, he panel -es and he group -es, suggesed by Pedron (999). he panel -es rejecs he hypohess ha here s no conegraon for he vecor q, rpd ), bu no for vecors rpd, lpd ) ( ( 6 Because of he assumpon of homogeneous auoregressve coeffcens, he Levn and Ln (993) es s encompassed by he IPS es. he resuls of he IPS es, however, are no conclusve. Alhough he es does no rejec he un-roo hypohess for q a he 5 percen level, does ndcae rejecon a slghly hgher levels (p-value = wh rend and p-value = whou rend).

13 - 2 - able. Un Roo ess Varable Levn-Ln Im-Pesaran-Shn es Sasc es Sasc Whou Wh Whou Wh rend rend rend rend q rpd ** ** d * lpd ** * ** oe: * ndcaes sgnfcance a he 5 percen level, and ** a he percen level. and ( q, rpd, d ). he group -es rejecs he no-conegraon hypohess for all hree vecors. 7 he group -es (unlke he panel -es) does no consran he frs-order correlaon n he resduals o be homogeneous under he alernave hypohess and s more relevan for our model, whch allows he shor-run dynamcs o vary across counres. hus, for he case where all varables are assumed o be nonsaonary, we consder (8) and (9) o represen relaons beween conegrang vecors. We esmae hese relaons by Dynamc Ordnary Leas Squares (DOLS), whch s an approprae framework for esmang and esng hypoheses for homogeneous conegrang vecors. 8 he relaons are esmaed n he followng form: 7 For vecors, ( q, rpd ), ( rpd, lpd ), and ( q, rpd, d ), he panel- es sasc s -.730*, -.093, and 0.278, respecvely. he correspondng sasc for he group- es s *, -.955*, and -.959*. An asersk ndcaes sgnfcance a he 5 percen level. 8 See Kao and Chang (2000), and Mark and Sul (2002) for a dscusson of he properes of panel DOLS.

14 - 3 - q n = + κ + π rpd + τ d + r = ( ξ n r rpd, + r + ζ r d, + r ) µ + u, (20) n = + χ + λ lpd + r = ϕ n r lpd, + r rpd ψ + v, (2) where n s he number of lags and leads used for he frs-dfference erms. Coeffcens of hese erms capure he shor-run dynamcs. We allow he shor-run dynamcs o be heerogeneous (.e., le ξ r, ζ r, and ϕ r dffer across ). If a lnear rend s ncluded, un roo ess sugges ha he explanaory varables n (8) and (9) are no negraed. We, hus, also consder he rend-saonary seng for esmang hese relaons. DOLS s a useful esmang procedure even n hs case. Snce frs-dfference erms are ncluded n hs procedure, he coeffcens of level erms represen long-run effecs. herefore, we esmae (20) and (2) wh rend varables o denfy long-run Balassa-Samuelson nfluences n he rend-saonary case. Basc Resuls ables 2 and 3 presen DOLS esmaes of dfferen varans of he real exchange rae equaon wh one lag and one lead of he frs dfference erms. 9 able 2 shows he esmaes of he equaon for he dversfcaon case excludng he erms of rade varable, and able 3 for he specalzaon case ncludng hs varable. For boh cases, we repor he resuls for homogeneous as well as heerogeneous shor-run dynamcs. Regressons and 4 n hese ables show esmaes of he basc form of he equaon whou a me rend. In all of hese cases, he effec of he relave prce varable s posve and sgnfcan. he predced value of hs varable s coeffcen equals γ (whch represens he share of he nonraded goods secor). he esmaed value, however, s greaer han uny n mos cases. As dscussed above, hs dscrepancy beween he predced and esmaed values could reflec a bas arsng from defnng he raded-goods secor oo broadly. he resuls also show ha he erms of rade varable exers a posve and sgnfcan effec when nroduced n he real exchange rae equaon (see able 3). hs fndng suppors he specalzaon verson of he model, n whch each counry produces a dfferen good. 9 he shor lengh of each me seres makes dffcul o explore he possbly ha he shor-run dynamcs nvolves hgher lags and leads. Indeed, here are no enough degrees of freedom o esmae (20) wh addonal lags and leads n he case of heerogeneous dynamcs. In he case of homogeneous dynamcs, however, we dd esmae (20) and (2) wh wo lags and leads, and found lle dfference n he resuls.

15 - 4 - able 2. he Exchange Rae Relaon: he Dversfcaon Case Varable Coeffcen Esmaes () (2) (3) (4) (5) (6) Homogeneous Shor-Run Dynamcs Heerogeneous Shor-Run Dynamcs rpd ** ** 0.79 **.066 **.066 ** ** (0.46) (0.46) (0.6) (0.56) (0.56) (0.73) rend (0.055) (0.060) rpd D * 0.40 * (0.29) (0.56) Adj. R-squared S. E. of Reg oes: Whe heeroskedascy-conssen errors are shown n parenhess. All regressons nclude counry-specfc and me-specfc dummy varables as well as hree frs-dfference erms. Coeffcens of he frs-dfference erms are consraned o be he same under homogeneous dynamcs, and allowed o be dfferen under heerogeneous dynamcs. D s a dummy varable, whch equals one for low-ncome developng counres and zero for ohers. he number of observaons equals 256. * ndcaes sgnfcance a he 5 percen level, and ** a he percen level. able 3. he Exchange Rae Relaon: he Specalzaon Case Varable Coeffcen Esmaes () (2) (3) (4) (5) (6) Homogeneous Shor-Run Dynamcs Heerogeneous Shor-Run Dynamcs rpd. **. ** 0.85 **.27 **.27 ** ** (0.43) (0.43) (0.63) (0.204) (0.204) (0.25) d ** ** ** * * ** (0.09) (0.09) (0.03) (0.29) (0.29) (0.4) rend (0.0540) (0.075) rpd D ** 0.60 * (0.43) (0.27) d D ** (0.23) (0.209) Adj. R-squared S. E. of Reg See noes for able 2. he number of observaons n able 3 regressons equals 246 because of mssng erms of rade daa.

16 - 5 - able 4 shows he resuls for esmang he relave prce relaon by DOLS. Regressons and 4 n hs able esmae he basc form of he relaon whou a me rend. he effec of he labor producvy ndex n boh regressons s posve and sgnfcan. Bu he esmaed values of s coeffcens n he wo regressons are subsanally below he predced value of uny. One possble explanaon of hs resul, suggesed above, s ha measurng employmen whou adjusmen for qualy changes leads o a downward bas n he producvy coeffcen. able 4. he Relave Prce Relaon Varable () (2) (3) (4) (5) (6) Homogeneous Shor-Run Dynamcs Heerogeneous Shor-Run Dynamcs lpd ** ** ** ** ** ** (0.042) (0.042) (0.05) (0.048) (0.48) (0.062) rend (0.028) (0.028) lpd *D * ** (0.076) (0.086) Adj. R-squared S. E. of Reg See noes for able 2. ables 2 4 also repor he resuls for he rend-saonary case, n whch a homogeneous lnear rend (wh he same coeffcen across counres) s ncluded n he wo relaons. he ables show (see regressons 2 and 4 n each able) ha he coeffcen of he rend varable s nsgnfcan n all cases, and he nroducon of hs varable n he regressons makes no dfference o he esmaes of Balassa-Samuelson parameers. We also nroduced heerogeneous rends n he wo relaons, bu hs varaon also made lle dfference o he resuls.

17 - 6 - Furher Analyss Our emprcal model ncludes me effecs o allow he effec of U.S. varables o be dfferen from ha of developng counres varables because of paramerc dfferences. me effecs are, n fac, sgnfcan n boh relaons. everheless, we also esmaed he wo relaons whou me effecs, bu dd no fnd a subsanal dfference n resuls. Our es of Balassa- Samuelson effecs s based on wo relaons suggesed by heory. Separae esmaon of hese relaons s useful n dsngushng wo key channels, hrough whch labor producvy affecs he real exchange rae. However, we also explored a varaon of he es ha combnes he wo relaons, and relaes he real exchange rae drecly o he labor producvy measure and he erms of rade ndex. Esmaon of hs relaon by DOLS also ndcaes ha boh varables are sgnfcan deermnans of he real exchange rae. We furher examned wheher he resuls are sensve o varaon n ncome levels. o explore hs queson, we dvded he developng counry sample no hgh- and low-ncome groups, and esed wheher coeffcens of Balassa-Samuelson varables dffer beween he wo groups. 20 Regressons 3 and 6 n ables 2 4 repor he resuls of hese ess. hese regressons nclude neracons beween explanaory varables and a dummy varable for he low-ncome group. hus, coeffcens of he varables show he effecs for he hgh-ncome group, and neracon erms represen he addonal effecs for he low-ncome group. Ineresngly, he resuls show ha he effec of he relave prce varable (n he real exchange rae regressons) s sgnfcanly hgher for he low-ncome group whle he effec of he labor producvy dfferenal (n he relave prce regressons) s sgnfcanly lower. he deparures from predced values are, hus, more pronounced for low-ncome counres. Snce daa problems are lkely o be more severe for he developng counres a he lower end of he ncome scale, hs fndng s supporve of our suggesed explanaon ha he esmaes of Balassa-Samuelson effecs are based because of measuremen errors. he resuls also ndcae ha he erms of rade effec s smaller for he low-ncome group. herefore, he suppor for he specalzaon verson seems o be weaker for he poorer developng counres. 2 Overall, hese resuls ndcae srongly ha Balassa-Samuelson effecs play a sgnfcan role n he deermnaon of he real exchange rae n he long run. 20 he classfcaon of counres n he wo groups s based on average ncome per capa for he sample perod. Each group ncludes egh counres (see Appendx II for he ls of counres n he wo groups). 2 hs resul may seem paradoxcal as producon and expors of low-ncome counres end o be less dversfed. However, specalzaon could also mean producon of goods (e.g., sophscaed manufacured producs) ha are sgnfcanly dfferenaed from goods produced elsewhere. Poor counres may be less specalzed n hs sense.

18 - 7 - V. COCLUSIOS he Balassa-Samuelson hypohess would seem o be especally relevan for developng counres where relave prces and producves are lkely o be more varable. Ye, here s lle or no emprcal evdence on wheher Balassa-Samuelson effecs can successfully explan long-run movemens of he real exchange rae n developng counres. hs paper presens new me-seres evdence for developng counres on he presence of Balassa- Samuelson effecs. o es for hese effecs, we esmae wo long-run relaons: relave prces (of nonraded goods) affec he real exchange rae n one relaon, and labor producvy dfferenals (beween raded and nonraded goods) affec relave prces n he second relaon. erms of rade also affec he real exchange rae (n he frs relaon) f a counry s specalzed n he producon of raded goods. A key new fndng of hs paper s ha he labor producvy dfferenal exers a sgnfcan effec on he real exchange rae va s nfluence on he relave prce of nonraded goods. 22 he paper also fnds ha erms of rade are a sgnfcan deermnan of he real exchange rae. Alhough he effec of relave prces and labor producvy varables operaes n he drecon ndcaed by he Balassa-Samuelson hypohess, he effec of relave prces s sronger and ha of producvy dfferenals weaker han he predced value. he paper also fnds ha he deparures from predced values are larger for developng counres wh lower ncome levels. We sugges an explanaon ha arbues he above resuls o bases caused by measuremen problems. hese problems are lkely o be more pronounced n counres wh lower ncomes and, hus, could accoun for dfferences n esmaed Balassa-Samuelson effecs beween counres a low- and hgh-ncome levels. Our ess of he Balassa-Samuelson explanaon are based on wo long-run relaons, whch are derved from heory under farly general condons, and can be mplemened emprcally for developng counres. Furher heorecal and emprcal analyss (requrng exra assumpons and more daa) could exend hese relaons and explore he role of addonal facors. 23 Such analyss s beyond he scope of he presen paper. he resuls of hs paper do sugges ha he Balassa-Samuelson mechansm s an emprcally useful framework for nvesgang he long-run behavor of he real exchange rae for developng counres. 22 Prevous work (for example, Lane and Mles-Ferre, 2004), based on usng GDP per capa as a proxy for he labor producvy dfferenal, has no found a sysemac effec of he producvy varable on real exchange raes n developng counres. We beleve ha we are able o denfy hs effec by usng a more approprae measure of labor producvy dfferenal based on secoral daa. 23 For example, Lane and Mles-Ferre (2004) explore he heorecal lnk beween he real exchange rae and ne foregn asses, and provde evdence ha he ne foregn asses poson s an mporan deermnan of he real exchange rae for developng (as well as developed) counres.

19 - 8 - APPEDIX I POEIAL BIASES DUE O MEASUREME PROBLEMS he raded-goods Secor Measure Includes onraded Goods Usng a ha over a varable o denoe he measured value, le he measured raded-goods prce be p ˆ = φ p + ( φ) p, > φ > 0, where φ s he wegh for he nonraded goods ha are mproperly ncluded n he raded-goods secor measure. he measured relave prce of nonraded goods s hen relaed o he rue prce as r pˆ = p pˆ = ( φ) rp. Le he correspondng relaon for counry be rpˆ = ( φ) rp, wh > φ 0. Usng hese relaons and leng pd ˆ = rpˆ rpˆ, we can express (8) as: r q = µ + κ + π rpd ˆ + τ d + u, where κ = κ + π[ /( φ) /( φ )] rpˆ and π = π /( φ). hus, f rˆ pd s used nsead of rpd n (8), s coeffcen would be based upward. oe ha hs problem need no nroduce a sysemac bas n (9). For example, f we also have l pˆ = φlp + ( φ) lp, hen l pˆ = lpˆ lp = ( φ) lp. Usng hs relaon and he correspondng one for counry, we can show ha he use of measured values n (9) would no bas he esmae of he effec of labor producvy dfferenal. Measured Employmen o Adjused for Labor Qualy Z Z Z Express he amoun of effecve labor n secor Z =,, as L E Lˆ Z =, where Lˆ s he Z acual (measured) quany of labor and E s he average qualy or effcency of labor. he measured labor producvy s relaed o he rue producvy (n logs) as Z Z Z Z Z l pˆ = y lˆ = lp + e. Suppose ha effcency s posvely correlaed wh rue labor Z Z producvy. Assume ha hs relaon akes he smple form: e = ρlp, ρ > 0. Recallng ha lp = lp lp, follows ha lp = lpˆ /( + ρ). Le lp ˆ = lp /( + ρ), ρ 0, be he correspondng relaon for counry. hen usng hese relaons, and leng pd ˆ = lpˆ lpˆ, we can express (9) as: l rpd = ψ + χ + λ lpd ˆ + v, where χ = χ + λ [ /( + ρ) /( + ρ )] lpˆ and λ = λ /( + ρ). hus, he use of lˆ pd nsead of lpd n (9) would bas he effec of he producvy varable downward.

20 - 9 - APPEDIX II DAA APPEDIX he daa se consss of a number of annual me seres for 6 developng counres and he Uned Saes. All seres cover he me perod. he selecon of developng counres and he choce of he me perod are dcaed by he avalably of he daa. Defnons and Daa Sources he U.S.-dollar exchange rae (S) and he consumer prce ndex (P) are from IMF, X M Inernaonal Fnancal Sascs (IFS). he expor and mpor prce ndexes ( P, P ) represen he prce/un-value seres from IFS, or f IFS daa are no avalable, expor and mpor prce deflaors from IMF, World Economc Oulook daabase. hese ndexes are used o calculae he erms of rade. he erms of rade daa are no avalable for Sngapore for he years and for urkey for he years Measures of he labor-producvy dfferenal and relave prce of nonraded goods are based on secoral daa on oupu, employmen, and prces. raded goods are represened by manufacurng and agrculure secors, and nonraded goods by all oher secors. Value added n consan local currency uns s used o measure oupus of raded and nonraded goods secors ( Y, Y ). Labor npus n he wo secors ( L, L ) represen he number of persons employed n each secor. Prce ndexes for raded and nonraded goods ( P, P ) are prce deflaors derved from value-added daa n curren and consan local currency uns. For he Uned Saes, all of hese seres are from OECD, Srucural Analyss (SA) daabase. For developng counres, he seres, Y, Y, P, and P, are from World Bank, World Developmen Indcaors (WDI). he prce deflaor for servces ec., whch accouns for he bulk of he nonraded goods secor, s used o esmae P. he daa on oal employmen n manufacurng are from World Bank, rade and Producon daabase. 24 A shor gap n hs daa for Cameroon was flled by lnear nerpolaon. Employmen n agrculure s derved from value added per worker and oal value-added seres gven n WDI. L s defned as he sum of employmen n manufacurng and agrculure obaned from he above sources. L s measured resdually as he dfference beween oal labor force (also from WDI) and L. A lmaon of he employmen daa s ha employmen n agrculure, manufacurng, and oher (nonraded) secors s no measured on a conssen bass. Labor producvy measures for raded and nonraded goods secors equal Y / L and Y / L, respecvely. Income Groups he 6 developng counres were dvded n low- and hgh-ncome groups accordng o average GDP per capa (from WDI) for he sample perod. Low- (hgh-) ncome group represens counres wh per-capa ncome smaller (greaer) han 2, 000 n 995 U.S. dollars. he counres n each group are lsed below. 24 See ca and Olarreaga (200) for descrpon of hs daabase.

21 APPEDIX II Low-Income Group Cameroon Colomba Ecuador Inda Jordan Kenya Morocco Phlppnes Hgh-Income Group Chle Republc of Korea Malaysa Mexco Sngapore Souh Afrca urkey Venezuela

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23 Mark, elson C., and Donggyu Sul, 2002, Conegraon Vecor Esmaon by Panel DOLS and Long-Run Money Demand, BER echncal Workng Paper o. 287 (Cambrdge, Massachuses: aonal Bureau of Economc Research). ca, Alessandro, and Marcelo Olarreaga, 200, rade and Producon, , World Bank Workng Paper o. 270, Washngon. Pedron, Peer, 999, Crcal Values for Conegraon ess n Heerogeneous Panels wh Mulple Regressors, Oxford Bullen of Economcs and Sascs, Vol. 6, pp Samuelson, Paul A., 964, heorecal oes on rade Problems, Revew of Economcs and Sascs, Vol. 46, pp