What's Really the Story with this Balassa-Samuelson Effect in the CEECs?

This paper offers a detailed assessment of the Balassa-Samuelson (BS) effect in eight Central and Eastern European countries (CEEC8). Several features distinguish this study from others: First, we investigate a variety of specifications of extended models. Nonhomogeneity of wages, deviations from PPP in tradables and demand side variables are found to importantly contribute to explain inflation differentials. Second, a variety of specifications is investigated. Third, we rely upon bootstrap inference for panel unit root and panel cointegration analysis. The bootstrap results are rather clear: No evidence for cointegration remains when resorting to bootstrap inference. To quantify the bias that may arise from incorrectly using cointegration techniques, we also quantify the BS effect from equations containing (nonstationary) 'cointegration' terms. Fourth, we present inflation simulations based on well specified scenarios. The results are as follows: Evidence for the BS effect is found. The BS effect is, however, rather small (around half a percent per annum) and not sufficient to explain the observed inflation differentials between the CEEC8 and the EU11. Using, despite the lacking evidence, cointegration techniques results throughout in substantially larger estimated effects. This suggests that studies relying upon cointegration may have overestimated the BS effect. The additional explanatory variables in the extended BS models allow for a satisfactory modelling of the observed inflation rates. The mean inflation simulations for the CEEC8 countries, based on the extended models, range from 2.77% for the Slovak Republic to 6.75% for Poland. These are well above the 2% inflation objective for the European Monetary Union.