Measuring the Impact of Fiscal Policy on Price Level in Pakistan

Abstract

A lack of price stability exerts harmful effects on the economy not only through changes in the price level but also through increased price level uncertainty. This paper investigates whether fiscal policy may have an impact on price volatility or not? The study further evaluates the short- and long-run impact of fiscal deficit and reserve money supply on price level in Pakistan. Dynamic short-run causality effects of fiscal deficit and seignorage towards price stability are also investigated in this study. Data is analyzed by autoregressive distributed lag model over a period of 1980-2010. The result indicates that if there is one percent increase in budget deficit, price level increases up to 0.11 percent, which shows that high fiscal deficit affecting inflationary expectations in the long-run. Result of the short-run causality test indicates that causality running from money supply to price level in Pakistan. The overall impact of the fiscal deficit on inflation operates through both increases in aggregate demand as well as associated growth in broad money.Thus, the role of money in inflation becomes obvious, but that process is largely conditioned by the fiscal deficit.

Keywords: fiscal deficit, seignorage, price level, cointegration, bounds testing, Pakistan

JEL Classification: E31, H50, H60