Every economy dreams of rapid growth. But what if success itself becomes a problem?

For three decades, Armenia, Azerbaijan, and Georgia have wrestled with a paradox: as their tradable goods industries grew more productive—think manufacturing, agriculture, anything you can export—wages climbed. Good news, right? Not entirely. Those wage gains spread to other sectors where productivity lagged behind. The result: stubborn, persistent inflation that central banks struggle to contain.

Economists call this the Balassa-Samuelson effect. The logic is elegant. When a factory worker in Tbilisi becomes twice as productive, her employer can afford to pay her more. But the barber next door? His productivity hasn't doubled. He cuts hair at roughly the same pace as before. Yet to keep him from leaving for the factory, his wage must rise too. And when wages rise without matching productivity gains, prices follow.

The new study tracked this phenomenon across Armenia, Azerbaijan, and Georgia from 1993 to 2022, quantifying what central bankers suspected but struggled to measure. The excess inflation—the portion driven purely by productivity imbalances—ranged from 0.1% to 0.8% annually. Modest figures, perhaps. But compounded over years, they reshape economies.

Why do these three countries matter? They're catching up. Fast. And catching-up economies face a structural tension. Their tradable sectors—industries competing on global markets—must modernize rapidly to survive. Foreign investment flows in. Technology transfers accelerate. Productivity surges. Meanwhile, non-tradable sectors like haircuts, restaurant meals, and legal services improve more slowly. They can't import efficiency the way factories import machinery.

The wage spillover happens because labor is mobile. A skilled worker won't stay in a low-productivity sector if high-productivity industries are hiring. Employers across the economy must compete for talent. Wages equalize, even when productivity doesn't.

This creates real exchange rate appreciation. A Georgian lari buys more than simple currency comparisons suggest, because domestic services cost more relative to tradable goods. For tourists, Georgia feels expensive. For exporters, competitiveness erodes.

Central banks in all three countries acknowledge this effect in their inflation targets. Georgia's National Bank explicitly sets its target at 3%, citing Balassa-Samuelson pressures. They're not fighting the effect. They're accommodating it.

The research applied two methods. The first compared each country's GDP per capita to its trading partners. The second examined GDP per worker. Both revealed the same pattern: persistent, measurable excess inflation correlated with productivity gains in tradable sectors.

But the effect isn't uniform. Economic crises weaken it. During downturns, the market mechanism that transmits wage pressures from tradable to non-tradable sectors breaks down. Workers accept lower wages to keep jobs. The productivity-wage link frays. Then, during recovery, the effect reasserts itself.

Exchange rate regimes matter too. Countries with floating currencies—like Armenia and Georgia for most of the study period—experience the effect differently than those with pegged rates. Under a floating regime, currency appreciation absorbs some pressure. Under a peg, inflation does all the work. Prices and wages must adjust internally since the exchange rate cannot.

Azerbaijan presents a particularly complex case. As an oil exporter, its economy faces additional pressures. Commodity price swings, foreign exchange shocks, and fiscal policy choices all interact with the Balassa-Samuelson mechanism. The country's central bank incorporates these factors into forecasting models that track inflation through multiple channels: exchange rates, foreign inflation, government spending, money supply, and productivity differentials.

Armenia shifted to inflation targeting in 2006, abandoning earlier monetary aggregate targets. The transition coincided with a period of double-digit growth and double-digit inflation. Much of that inflation was imported—rising global commodity prices drove domestic costs up. But beneath the imported component, the Balassa-Samuelson effect persisted. Even after external shocks faded, excess inflation remained.

Georgia's trajectory offers lessons in credibility. After hyperinflation in the early 1990s reached 15,607%, the country pegged its currency to the dollar. Inflation plummeted. But the 1998 Russian crisis forced a rethink. The currency floated. Inflation jumped briefly, then stabilized. The central bank's commitment to price stability, even amid crisis, rebuilt trust. Inflation expectations anchored. Today, the Balassa-Samuelson effect operates within a credible policy framework rather than destabilizing it.

The study's findings align with broader research on Central and Eastern European countries that joined the European Union. Those economies faced similar pressures. Productivity surged in tradable sectors. Wages rose economy-wide. Inflation exceeded the eurozone average even as exchange rates appreciated. The Balassa-Samuelson effect explained part—though not all—of the inflation differential.

What the effect doesn't explain matters as much as what it does. Regulated prices, fiscal policy, commodity shocks, and shifts in exchange rate regimes all contribute to inflation beyond productivity differentials. The research acknowledges this limitation. The Balassa-Samuelson effect is one mechanism among many.

For policymakers, the implications are profound. If part of your inflation is structural—baked into the development process—then fighting it with monetary tightening alone imposes unnecessary costs. Raising interest rates to crush inflation driven by productivity gains means sacrificing growth for no clear benefit. Better to accommodate the effect, set realistic targets, and focus monetary policy on inflation you can actually control.

The three South Caucasus countries appear to have learned this lesson. Their inflation targets reflect the reality of catch-up growth. Their policy frameworks distinguish between temporary shocks and persistent structural pressures. And their central banks communicate these distinctions to anchor expectations.

The research also matters for how we think about economic convergence. When poor countries grow rich, their prices rise relative to wealthy countries. That's not a policy failure. It's a sign of success. Real living standards improve even as nominal price levels climb. Ignoring this pattern leads to misguided conclusions about competitiveness and exchange rate misalignment.

Looking ahead, the Balassa-Samuelson effect will continue shaping inflation dynamics across the developing world. As countries industrialize, automate, and integrate into global supply chains, productivity gaps between sectors will persist. Wage pressures will transmit from high-productivity to low-productivity industries. Inflation will exceed what purchasing power parity alone predicts.

Understanding this mechanism helps us interpret economic data more clearly. When we see inflation in a rapidly growing economy, we shouldn't automatically assume monetary policy failure. We should ask: how much stems from productivity-driven wage growth? How much from exchange rate regime choices? How much from external shocks?

The Balassa-Samuelson effect reminds us that economies are not machines. They're ecosystems where changes in one sector ripple through the whole. Productivity gains in factories raise wages for barbers. Growth creates pressures that look like problems but signal transformation. And the same forces that drive development—rising productivity, capital accumulation, technological catch-up—also reshape price levels in ways that simple monetary models miss.

For Armenia, Azerbaijan, and Georgia, three decades of data tell a consistent story. The effect is real. It's measurable. And it's persistent. Central banks that acknowledge it can design better policy. Those that ignore it risk fighting ghosts.

Credit & Disclaimer: This article is a popular science summary written to make peer-reviewed research accessible to a broad audience. All scientific facts, findings, and conclusions presented here are drawn directly and accurately from the original research paper. Readers are strongly encouraged to consult the full research article for complete data, methodologies, and scientific detail. The article can be accessed through https://doi.org/10.1007/s10958-025-07690-8