more productive, and hence, the wealthier one. This means that which implies that . So with a same (world) price for tradable goods, the price of nontradable goods will be lower in the less productive country, resulting in an overall lower price level. The effect in more detail A typical discussion of this argument would include the following features: Workers in some countries have higher productivity than in others. This is the ultimate source of the income differential. (Also expressed as productivity growth.) Certain labour-intensive jobs are less responsive to productivity innovations than others. For instance, a highly skilled Zurich burger flipper is no more productive than his Moscow counterpart (in burger/hour) but these jobs are services which must be performed locally. The fixed-productivity sectors are also the ones producing non-transportable goods (for instance haircuts) - this must be the case or the labour intensive work would have been off-shored. To equalize local wage levels with the (highly productive) Zurich engineers, Zurich fast food employees must be paid more than Moscow fast food employees, even though the burger production rate per employee is an international constant. The CPI is made up of: local goods (which in richer countries are more expensive relative to tradables) Tradables, which have the same price everywhere The (real) exchange rate is pegged (by the law of one price) so that tradable goods follow PPP (purchasing power parity). The assumption that PPP holds only for tradable goods is testable. Since money exchange rates will vary fully with tradable goods productivity, but average productivity varies to a lesser extent, the (real goods) productivity differential is less than the productivity differential in money terms. Productivity becomes income, so the real income varies less than the money income does. This is equivalent to saying that the money exchange rate exaggerates the real income, or that the price level is higher in more productive, richer, economies. Equivalent Balassa–Samuelson effect within a country The average asking price for a house in a prosperous city can be ten times that of an identical house in a depressed area of the same country. Therefore, the RER-deviation exists independent of what happens to the nominal exchange rate (which is always 1 for areas sharing the same currency). Looking at the price level distribution within a country gives a clearer picture of the effect, because this removes three complicating factors: The econometrics of purchasing power