Fiscal Deficit and Inflation: Evidence from Pakistan

Abstract

This study investigates the relationship between fiscal deficit and inflation by using annual data ranging from 1976 to 2010. The literature on the subject provides ample evidence that fiscal deficit causes inflation and inflation also causes fiscal deficit thus implying a bi causality between the two. Since Pakistan’s economy is also passing through a difficult phase where inflationary pressure is persisting along with very high level of fiscal deficit, it is important that these two phenomena are well understood to explore policy solution. Using Granger causality approach, the study found that, unlike many other economies there is a unidirectional relationship between fiscal deficit and inflation in Pakistan and the causality runs from fiscal deficit to inflation. Moreover, a long run relationship also exists between the two macro variables. The study also checked the robustness of these results by changing the specifications of the model and found consistency in results. Not only that Primary Fiscal Deficit has been found to be inflationary in Pakistan, the results also proved the Keynesian theory that when deficit is financed through interest bearing assets, it also leads to inflation through the interest rate channel.