1 Problem Statement
2.1 Theoretical Background
2.1.3 Choice of Variables
(1)
In choosing a scale variable for the specification of import demand a choice has to be made between 'real incarne' and 'real expenditure'. The issue is whether domestic demand for foreign goods i.e. imports should be properly related to the domestic demand for all goods. The Keynesian preference for 'real incarne' follows naturally from the foreign-trade multiplier, incarne driven view of balance-of-payments adjustment. In a monetary oriented framework, (see for example, Aghevli and Khan (1980)) the tendency has been to favor real expenditure over real mcome. This is mainly because it can be related to the difference between actual and real money
balances and therefore assures the role for money in the trade and balance of payments adjustments.
Equation (1) typically assumed that the demand for imports is independent of the priee of non tradable goods, therefore, only the relative priee of import to domestic tradable goods need to appear in the import demand equation. The rationale is that a consumer engages in a two-step consumption process. He first allocates his expenditure between ali tradable and non-tradable goods and then allocates his expenditure on tradable goods between imports and domestic tradable goods.
The problem then encountered by researchers is the lack of priee indices for domestic tradable goods. Inevitably, proxies like wholesale priee index and GDP deflators are used. These, indices contain nontrivial shares of products that might be reasonably considered non-tradable goods(Goldstein and Officer (1979)). This being the case, the estimation of import demand equations using wholesale priee indices or GDP deflator will usually yield an identical cross priee elasticity for tradable goods and non-tradable goods.
Fortunately, Goldstein et al. (1980) showed that for the majority of the countries they studied, the priee of non-tradable goods are insignificant in determining the demand for imports. This validates the inclusion of only relative priee of imports to domestic tradable goods in the import demand equation and therefore lends support to the assumption that a consumer engages in a two step consumption process that eventually separates their consumption of tradable goods between imports and domestic tradable goods.
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Equation (1) thus represents a traditional import demand model and these models have performed weil when estimated. However, the rehabilitation of the quantity theory of money by the Chicago School introduces the significance of the monetary approach to balance of payments especially when dealing with developing countries. This is mainly because it was observed that less developed countries typically have simpler financial structures than the more developed countries. In the absence of well-developed assets markets and financial instruments, there are relatively very few alternatives to holding funds in monetary form or spending them on domestic or foreign goods. This implies that residents tend to hold more money than in a more complex financial structure. Thus the amount of money in circulation or broadly speaking the money supply will influence import demand.
Traditional import demand models also assumes that the currency that is needed to buy imports is available and thus there are no foreign exchange constraints. As observed by Polak and Rhomberg (1962; ppll3), as a group, developing countries have had to adjust their foreign exchange, mostly for imports, to the foreign exchange receipts on account of experts. Piekarz and Skekler' s (1967) study on "Induced Changes in Trade and Payments" supported the notion that export eamings influence imports when their findings show that for a sample of developed and developing countries, experts eamings significantly influence imports. Thus foreign exchange constraint has been considered as a determinant of imports especially for developing countries.
It is also important to note that equation (1) is presented as an equilibrium relationship without any reference to time. In the real world, the presence of adjustment costs and of incomplete information implies that the adjustment of dependent variables to explanatory ones will not be instantaneous. This means that importers will not always be on their long-run demand schedules.
To capture the effect of lags in the adjustment process, lagged variables have been incorporated into import demand equations. The approach frequently employed by researchers in modeling dynamic trade behavior is to specify the equation within a framework of a general distributed-lag mode! with geometrically declining weights.
A popular lag mode! is the Koyck's model, which for a specifie case of import demand is written as:
Where
p
measures the response of actual imports to the demand for imports and is bounded (0, 1 ). IfP
equals unit y th en actual imports equals desired imports and ifp
is zero it implies th at equilibrium is never reached. A variant of the Koyck's model is the partial adjustment model that states that imports adjust to the difference between the demand for imports and actual imports in the previous period. This model is represented as follows:By substituting for Mct in equation (1), a redueed form equation that adds the lagged import term is obtained. A second variant of the Kyock's model is formed according to the adaptive-expectations model of Cagan (1965). In this case the demand depends not only on actual priees but also rather on sorne notion of expected priees. The equation obtained with this variant is fairly similar to that yielded by the partial adjustment mechanism.
Partial adjustment mechanism is very popular with researchers because the results obtained have been generally satisfactory and easily interpreted. Despite its popularity this mechanism imposes a restrictive dynamic structure in the data, which will be more desirable to test rather than impose a pnon. The realization that variables such as real income and imports can be decomposed into a stationary and a non-stationary component has called for the adoption of a more flexible dynamic specification of trade data. Consequently, co-integration technique has been used to address the inherent specification problem in partial adjustment mechanism.
A frequently asked question is whether it is neeessary to estimate disaggregated or aggregated relationship. Theil (1954) discovered that for an aggregate import demand equation, the real income and priees depend not only on the corresponding parameters of the disaggregated relationship but also on the parameters of the other included variables. This means that the aggregate real income coefficient will be a weighted average of the disaggregated real income and priee coefficients. He thus concluded that unless ali the disaggregated coefficients are equal, estimation of aggregate relationship would result in a specification bias. It should be noted that while disaggregation may be preferable in principle, there has been sorne controversy on its merits in practiee. If the disaggregated data are accurate and the component equations well
specified, then disaggregation always results in more information. But Grunfeld and Griliches (1960) and Aigner and Goldfeld (1974) make the point that disaggregated data are generally subject to larger measurement errors than aggregate data, and further that disaggregated functions are more likely to be mis-specified than aggregate relationship. In such a case, it may be advisable to estimate aggregate relationship.