Volatility in Fiscal Policy and Terms of Trade: An ARDL Analysis of Business Cycle Fluctuations in Pakistan

Abstract

Volatility in fiscal policy and terms of trade has diverse macroeconomics implications. This study examines the impact of government spending volatility and terms of trade volatility on output volatility in Pakistan by utilizing time-series data from 1980 to 2021. After confirming the mixed order of integration of variables through unit root testing and the existence of a long-run relationship (cointegration) among variables, the long-run and short-run coefficients are estimated using the Autoregressive Distributed Lags (ARDL) estimation technique. The findings depict that volatility in fiscal spending and terms of trade increases volatility in the output, i.e., amplify fluctuations in the business cycle and leads to macroeconomic instability both in the short run and long run. Therefore, stable and flexible fiscal and trade policies should be designed to minimize the cost of output volatility. The long run empirical evidence from the control repressors indicates that trade openness, foreign direct investment, financial development, and capital formation stabilize output volatility.

Keywords:

Public Spending Volatility, Output Volatility, Terms of Trade Volatility, ARDL Modeling, Pakistan.