Analyzing the Role of Monetary and Fiscal Policy Coordination in Pakistan within the New Keynesian Framework

Abstract

After the global financial crisis of 2008, the coordination between monetary and fiscal policies gained increasing importance. This paper develops a macro econometric model for a small open economy with monetary and fiscal coordination where market friction is introduced and estimated by using the New Keynesian framework. Using Pakistani data, the parameters are estimated for historical period ranging between 1975 to 2016. The structural parameters estimation shows weak monetary and fiscal policy coordination. Further evidence is gained from impulse response results which also confirmed weak relationship as monetary and fiscal variables converged to equilibrium state after sufficiently long lag. Based on this evidence, it is recommended that monetary and fiscal sides need to focus on demand management policies to ensure price stability in the economy. It is clear that fiscal policy has been a dominant force and despite independence of the central bank, the monetary policy has been subservient to the fiscal pressures. This requires strengthening of the monetary policy mechanism through appropriate coordination platforms and accredited measures for appropriate statistics, requisite assurances and appraisal of policy outcomes.