Have you ever had a haircut in South East Asia, a kebap in Zurich or been a sex tourist (just to grab your attention). If so than you, or the kebap seller in Zurich, have probably benefitted from the Balassa-Samuelson effect. This is something you learn in your intermediate macro series. But, to be honest, I was never that interested in macro. So you forget. But at least it gives you the excitement to learn again about a theoretical concept that immediately explains you many of your every-day life observations. I thought I share this excitement with you.
This year I attended a conference in Boston and stayed in a hotel down-town. I just had arrived from Europe and was hungry as hell at 6am. So I went to the lobby and enjoyed a nice breakfast* for $28 at an exchange rate of almost 1:1 to the Euro. It got me thinking how relative price levels (e.g., restaurant prices vs. prices you pay in a shop) can be so different compared to Europe. People from Massachusetts must make a load of money in other occupations to be able to afford such a price level.
I got the story about right. Think of two countries, R(ich) and P(oor), and two goods, A and B. Country R is very efficient in producing A and this good is tradable. Wages are related to productivity, so there are high wage levels in the sector producing A. Now assume that good B is not tradable. In addition, in sector B productivity gains are not so pronounced. There are natural limits to becoming more productive as a hairdresser or restaurant chef. But in country R, nevertheless, wages in sector B have to be somewhat close to wages in sector A. Otherwise, nobody would ever offer these services and sector A would attract all the labor supply.
The exchange rate does not fully reflect this. It adjusts so that the prices for the tradable good A are more or less equal between R and P. Otherwise there would be arbitrage possibilities. But nobody takes a flight to Bangkok just to get a cheap haircut there. As a result, the exchange rate does not equalize prices for B and thus relative price levels. Therefore you can feel like a king on your trip to Riga but probably won’t eat out that often in Oslo.
By the way, the same effect works within a country or in currency union. Clothes from Zara cost everywhere the same. At the same time exchange students from Spain might find it outrageous that a €7 ticket to a student party doesn’t include free drinks all night (maybe a little exaggerated but true anecdote).
* I had some nice scrambled eggs with tasty coffee and nice service. The next day I had breakfast at the bagel store around the corner which was much cheaper. So the real lesson here is probably not to have breakfast in hotel lobbys down-town.