Trade, persistent habits and development - a dynamic CGE model analysis

This paper presents a recursively dynamic CGE model of international trade with an alternative specification of imports demand and trade substitution elasticities, building on theoretical models of habit persistence and habit formation. We test and demonstrate with illustrative policy experiments how different imports demand specifications affect the short-run and long-run outcomes of trade policy shocks, focussing on imports and exports of cereal grains in selected developing countries. Our results show that the inclusion of habit persistence can have significant effects on the expected trade policy outcomes, and hence the functional form of import demand in a global trade CGE model is not a trivial choice. Our model builds on the dynamic version of the GTAP model, modifying the regional imports demand system so as to explicitly account for the different short and long run trade elasticities. The model does not replace the more sophisticated applications focussing on intensive and extensive margins but provides a simplified solution in some cases yielding similar results as monopolistic competition or firm heterogeneity and allowing extensions to tackle issues related to long-run scenario development. The experiments show that the impact of habit persistence goes beyond a straightforward adaptation path towards the standard model reference results when the policy change affects global trading patterns by treating exporting countries differently. A trade-enhancing policy shock results in higher long-run volume of trade and private consumption when habit persistence in included in the model, whereas particularly investments and subsequently GDP are lower than in the standard model Reference simulations. Long-run welfare effects measured by equivalent variation are also more favourable with habit persistence included, but as the short-run effects are negative, the overall impact depends on the discount factor applied.