Penn Effect - History

History

Classical economics made simple predictions about exchange rates; it was said that a basket of goods would cost roughly the same amount everywhere in the world, when paid for in some common currency (like gold)1. This is called the purchasing power parity (PPP) hypothesis, also expressed as saying that the real exchange rate (RER) between goods in various countries should be close to one. Fluctuations over time were expected by this theory but were predicted to be small and non-systematic.

Pre-1940, the PPP hypothesis found econometric support, but some time after the Second World War, a series of studies by a Penn team documented a modern relationship: countries with higher incomes consistently had higher prices of domestically produced goods (as measured by comparable price indices), relative to prices of goods included in the exchange rate.

In 1964 the modern theoretical interpretation was set down as the Balassa-Samuelson effect, with studies since then consistently confirming the original Penn effect. However, subsequent analysis has provided many other mechanisms through which the Penn effect can arise, and historical cases where it is expected, but not found. Up until 1994 the PPP-deviation tended to be known as the "Balassa-Samuelson effect", but in his review of progress "Facets of Balassa-Samuelson Thirty Years Later" Paul Samuelson acknowledged the debt that his theory owed to the Penn World Tables data-gatherers, by coining the term "Penn effect" to describe the "basic fact" they uncovered, when he wrote:

The Penn effect is an important phenomenon of actual history, but not an inevitable fact of life.