Crowding-out hypothesis in a vector error correction framework: A case study of Pakistan

Abstract

A dynamic model is used to test short-run and long-run behaviour of private and public investment and the rate of economic growth. The study provides an insightful means for economic managers aiming at determination of appropriate size of the public sector by examining whether the crowding-out hypothesis holds true for Pakistan or not. We utilise multivariate co-integration techniques to develop a vector error-correction model, useful for probing long run effects along with the short run dynamics, of public investment on private capital formation and economic growth for the period 1964-2001. The results of vector error correction model and impulse response analysis show a positive long run correlation between public and private investment, thereby implying the absence of crowding-out phenomenon in Pakistan. These findings suggest that the policy of fiscal consolidation, which is based on IMF stabilisation programme and being pursued since 1988 is one of the important determinants of declining investor confidence and deceleration in both private investment and the rate of economic growth.