Purchasing power parity, wages and inflation in emerging markets

Persistent deviation of real exchange rates from purchasing power parity (PPP) values is a puzzle, since nominal shocks, which cause such deviation, are expected to have only short-run effects. If some goods are non-traded, Balassa Samuelson (BS) showed how such deviations occur and explain why the price level is relatively higher in advanced economies. But then, consistently higher inflation in emerging or developing economies (EDE) is another puzzle. The paper presents a framework giving a new simple proof of the BS result. If the assumption that the price level is fixed for the EDE is dropped, nominal depreciation interacting with different types of wage rigidities can explain higher inflation, as nominal wages rise in response to a nominal depreciation. Then monetary shocks have persistent effects but these shocks can arise from large capital flows independent of changes in domestic money supply. Evidence from India supports the hypotheses.