Relative Prices, Non-Homothetic Preferences, and Product Quality

This paper develops a novel theory of price level differences across countries. In a model characterized by a quality hierarchy in demand, we demonstrate that GDP per capita growth leads to higher average product quality in consumption as demand shifts toward higher quality goods. In turn, such structural change in expenditure shares engenders ongoing labor reallocations toward the higher-quality goods, which are more difficult to produce, thus commanding higher prices. As a result, economic growth induces a rise in the aggregate price level of the country. As we show, this implies that countries experiencing higher relative levels of economic development observe relatively appreciated real exchange rates.