The inflation target of the ECB: does the Balassa-Samuelson effect matter?

Abstract

This paper argues that the Balassa-Samuelson effect is not of importance for the inflation target of the ECB. First, econometric tests of the Balassa-Samuelson effect suggest that its econometric significance is weak at best. Second, countries in the process of catching up require a real devaluation in the sector of tradable goods to maintain balance-of-payments equilibrium which counters the real appreciation resulting from a relative increase in service prices. It follows that whereas the Balassa-Samuelson effect could, at least in theory, be used to justify an inflation target well above zero, thedifference in productivity growth and thus the difference in the size of the Balassa-Samuelson effect between countries as such cannot.