An Empirical Examination of Relative Income Hypothesis: Evidence from Pakistan

Abstract

The present study empirically investigates the relevance of the various specifications of relative Income hypothesis (RIH) in the case of Pakistan. World Development Indicators’ data is analyzed over the period of 1986 to 2016. This study tests the existence of income, consumption, and habit ratchet effects at the National level. Based on stationarity tests the techniques of Box Jenkin, Two Stage Least Square, Generalized Methods of Moments, and Limited Information Maximum Likelihood Method are utilized to estimate the four versions of relative income hypothesis. Findings of this research validate the significant prevalence of three types of ratchet effects in case of Pakistan. In Duesenberry-Eckstein-Formm (DEF) model, habit ratchet effect is found to be stronger than income ratchet effect. Whereas in modified Davis model Consumption ratchet effect exceeds the habit ratchet effect. It is observed that long run marginal propensities to consume are closer to one which demonstrates smooth consumption behavior over long period in Pakistan. The estimated short run marginal propensities to consume are observed to be less than long run marginal propensities to consume that accords with the existing consumption theory. These findings imply that all ratchet effects put pressure upon consumers to maintain the highest standard of living enjoyed in the past. In this process households do not retain balance between savings and consumption. Based on these findings, it is suggested to consider the impact of societal factor in formulating policies to shape the consumption patterns.