The fiscal reaction function and the transmission mechanism for Pakistan

Abstract

In developing economies such as Pakistan the fiscal transmission mechanism needs to be identified, as active fiscal policy is practised and large seigniorage revenues exist. In this context, the present study aims at estimating the fiscal policy reaction function and identifying the fiscal policy transmission mechanism. More specifically, the Vector Autoregression (VAR) model, containing three variables (output gap and inflation as policy objectives and fiscal deficit as a percentage of GDP), has been estimated as a fiscal instrument. We find evidence of fiscal policy in Pakistan being endogenous over the period 1965 to 2006. Although the response to both the variables is significant, we find only pro-cyclical response of fiscal policy to the business cycle fluctuations specifically in the periods of boom. The effect of fiscal policy changes on output and inflation is not significant. We also find the evidence of contemporaneous response of policy to the state of the economy, but the policy is not forward-looking at all. © The Pakistan Development Review.