A Reconsideration Of Prices Using The Balassa-Samuelson Theory: Evidence From Japan

This paper theoretically and empirically reevaluates price policy associated with deflation using the Balassa-Samuelson theory (Balassa (1964), Samuelson (1964)). The theoretical model developed in this paper shows the relative price level (or real exchange rate) between two countries is explained by the relative wage rate and the relative labor productivity between two countries. The empirical results confirm that relative wage rate has more impact on relative price, compared to the relative labor productivity. Since the convergence of price levels in the long run is confirmed in this paper, the theory developed implies that the tendency of nominal appreciation (depreciation) of a country’s currency causes declining (increasing) nominal wages and price levels in the long run under a free market economy. To raise the price level, it is necessary to raise labor productivity which causes a rise in the nominal wage rate in the longer run and which eventually results in a rise in the price level. The policy implication is that operating an effective price policy is difficult for countries experiencing deflation