Academic journal article National Institute Economic Review

Prices and Price Convergence in Emerging Europe: An Overview

Academic journal article National Institute Economic Review

Prices and Price Convergence in Emerging Europe: An Overview

Article excerpt

This paper seeks to provide a comprehensive overview of the long-term factors that explain divergent price levels across developed and emerging European countries. We provide stylised facts about the structural factors that influence market and non-market-based service, house and goods prices. The stylised facts show that there is much more behind differences in price levels among European countries than the much heralded Balassa-Samuelson effect and that prices other than those of market services are potential determinants of price levels and inflation rates in emerging Europe. Finally, we sketch out the possible mismatches between price level convergence and inflation rates.

Keywords: Price level; inflation; Balassa-Samuelson; tradables; house prices; regulated prices; Europe; transition; real convergence; catching-up

JEL Classifications: E43; E50; E52; C22; G21; 052

I. Introduction

Divergence within the European Union with regard to the level of economic development and price levels, and the recent euro adoption by Slovenia (2007) and Cyprus and Malta (both 2008) (1) has spurred considerable interest among policymakers and in academic circles as to the driving forces of differences in price levels and inflation rates. One major question is whether the lower initial price levels and the ongoing catching-up process necessarily leads to substantially higher inflation rates over a long-term horizon. The dominant view is that most of the differences in price levels and the observed inflation rates can be well explained by the Balassa-Samuelson effect.

Obviously, this view is fairly simplistic and ignores the fact that the basic assumptions of the Balassa-Samuelson effect may be violated in practice and that a large number of other factors may possibly have an effect on price levels and inflation rates. Table 1 gives a first flavour about the fact that lower price levels in Central and Eastern Europe are also a result of lower goods prices, whereas the Balassa-Samuelson effect postulates that differences in price levels should originate in the service sectors.

The aim of this paper is to summarise the driving forces of price levels and inflation rates that can be associated with the long-run real convergence of fast growing European countries. In particular, we propose to provide an overview of the factors that may affect not only market-based services (Balassa-Samuelson effect) but also relate to prices of different types of goods, non-market services and house prices. (2) However, quantifying the relative importance of the different factors is beyond the scope of this paper.

The remainder of this study is structured as follows. Sections 2, 3, 4, 5 and 6 deal with the prices of market-based services, non-market based services, house prices, the prices of goods and the role of the tax system, respectively. Section 7 sketches out the possible mismatch between price level convergence and inflation rates. Finally, Section 8 summarises the main findings of the paper.

2. The prices of market-based services

The well-known proposition put forth by Balassa (1964) and Samuelson (1964) is widely used in the economic profession to explain cheaper services in less developed countries. Let us recall briefly their argument. It is assumed that an economy is split into two sectors, producing tradable and non-tradable goods, and that market forces are at work in both sectors. This has important implications, because in the public and other regulated sectors, wages and prices will not behave as they would in market-based sectors (see next section for more discussion on price regulation). One of the key assumptions is that purchasing power parity (PPP) holds for the tradable sector, i.e. prices in the domestic and foreign economies are the same once they are converted to the same currency unit. Another important assumption is that wages are linked to the level of productivity in the open sector and that wages tend to equalise across sectors so that the wage level in the closed sector equals that in the open sector. …

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