The price of development: The Penn-Balassa-Samuelson effect revisited

The Penn-Balassa-Samuelson effect is the stylized fact about the positive correlation between cross-country price level and per-capita income. This paper provides evidence that the price-income relation is actually non-linear and turns negative among low income countries. The result is robust along both cross-section and panel dimensions. Additional robustness checks show that biases in PPP estimation and measurement error in low-income countries do not drive the result. Rather, the different stage of development between countries can explain this new finding. The paper shows that a model linking the price level to the process of structural transformation captures the non-monotonic pattern of the data. This provides additional understanding of real exchange rate determinants in developing countries.