The Fiscal and Monetary Policy Responses to Inflation in the Long Run: A Case Study of Pakistan Economy

Abstract

The chronic current account  situation of Pakistan as a result of foreign borrowing has caught the attention of researchers and policy makers specifically the aftermath of the flexible exchange rates adaptation that in turn caused frequent price fluctuations within the economy. It has now become a challenge for Pakistan to bring stability in prices with stable economic growth especially after the pandemic situation. What factors determine and can target these price fluctuations that affect the well-being of common man. The “Ricardian regime” favors monetary policy to be a pertinent component to determine the level of prices. The “non-Ricardian regime” supports fiscal policy as an important determinant of prices and their movement. Therefore, an empirical research is conducted to analyze whether “Ricardian or non-Ricardian regime” is responsible for these price fluctuations. For this purpose, the present study examines the impact of fiscal and monetary policy stance on inflation in Pakistan from 1980 to 2022 using the autoregressive distributed lag model. The finding reveals that the fiscal-consolidation along with expansionary monetary policy significantly influence inflation in both short and long terms. A monetary expansion causes inflation while fiscal-ease does not contribute to inflationary pressures in Pakistan economy. The results suggest that inflation in Pakistan is more responsive to other fiscal and monetary factors than fiscal ease in the long run. Moreover, moderate fiscal-consolidation along with contractionary monetary policy can help manage inflationary pressures and promote growth.