Intertemporal substitution in import demand and the role of habit formation: an application of Euler equation approach for Pakistan

Introduction The study examines the importance of intertemporal substitution in import demand considering the role of habit formation. A two-goods version of the permanent income model is used in which time-non-separability in consumers’s preferences is assumed. The model is estimated using annual data for Pakistan at disaggregated level covering the period from 1977 to 2017. Objectives The objective of the study is to estimate elasticities of substitution along with parameters of habit formation for consumption goods at a disaggregated level. Method The study employs co-integration for the estimation of parameters of elasticities of substitution and generalized method of moments (GMM) for the estimation of the parameters of habit formation from Euler equations. Findings The estimates of intertempral elasticity of substitution suggest that the nature of commodity group (necessity/luxury) plays an important role when consumers are making intertemporal choices. Moreover, the study finds that intratemporal elasticity of substitution is larger than intertempral elasticity of substitution in almost all cases in Pakistan, suggesting that imported and domestic goods are best described as substitutes in Edgeworth-Pareto sense. In addition, the inclusion of habit formation delivers results with plausible signs and the habit formation process seems significant for certain commodity groups including tea, beverages, tobacco products and drugs. Conclusion The study concludes that there is a possibility of crowding out effect on domestic consumption and the depreciation of local currency may improve Pakistan’s balance of trade.