Dynamic Interplay: Evaluating Fiscal and Monetary Policies in Shaping Pakistan’s Macroeconomic Landscape

Abstract

This study evaluates the dynamic interaction between fiscal and monetary policies and their collective impact on Pakistan’s macroeconomic performance from 1980 to 2023. Using a Vector Autoregression (VAR) model along with analyses of Impulse Response Function (IRFs) and Variance Decomposition (VDs), the research examines how key macroeconomic variables such as growth rate of gross domestic product, inflation, debt, unemployment and exchange rate respond to fiscal and monetary policy shocks. Monetary policy is represented by interest rate, while fiscal policy is measured through the budget deficit as a percentage of GDP. The findings of the study indicate that monetary policy exerts a stronger influence on inflation, GDP growth, and exchange rate, whereas, fiscal policy’s role is more prominent in unemployment management. The results reveal that a tight monetary policy, slows down economic growth, raises unemployment and depreciates the exchange rate in the short run, while helping in controlling inflation after a few lags. On the other hand, fiscal expansion, while having limited immediate impact on growth, contributes to inflationary pressures in economy. Results of variance decomposition suggest that monetary policy has relatively greater potential in determining the variances of GDP, inflation and debt while fiscal policy dominates in explaining variation in unemployment. The study concludes that monetary policy has relatively more potential in shaping Pakistan’s macroeconomic landscape. This study emphasizes the importance of fiscal and monetary policy coordination, as well as exchange rate stabilization, in preventing supply shocks. Additionally, the study supports the autonomy of the State Bank of Pakistan in ensuring effective monetary management free from political influence. The findings provide policymakers with valuable insights into optimizing fiscal and monetary policy coordination for long-term economic growth and stability.

Keywords:

Monetary Policy, Fiscal Policy, Fiscal Monetary Interaction, Policy Effectiveness, Macroeconomic Performance.