Modelling the Balassa-Samuelson Effect in Australia

This paper examines the Balassa-Samuelson hypothesis in Australia using the ARDL cointegrationframework. Evidence was found of a significant long-run relationship between real exchange rate andAustralia-US productivity differential during the period of 1950-2003. The results indicate that a one per centincrease in labour productivity in Australia relative to the US will lead to 5.6 per cent appreciation in the realexchange rate of Australia. The estimated coefficient for the error correction term is -0.1983 and is highlysignificant, indicating that the deviation from the long term real exchange rate equilibrium path is correctedby nearly 20 per cent over the following year. The Author suspects that the elasticity coefficient is “overestimated”due to the exclusion of relevant explanatory variables in the analytical model. The real exchangerate movements are affected by real fundamentals and policy-induced shifts in its real fundamentals. Thefundamentals include the terms of trade, government expenditure, real interest rate differentials, net foreignliabilities among others along with labour productivity differential.