Fiscal and Monetary Policy Interactions in Pakistan Using a Dynamic Stochastic General Equilibrium Framework

Currently Pakistan’s economy is under stress and registered a sluggish growth for many years in a row. The performance of major economic indicators is not satisfactory. Low investment, double digit inflation, fiscal imbalances and low external capital inflows indicates the severity of the grave economic situation. This paper investigates fiscal and monetary policy interaction in Pakistan using dynamic stochastic general equilibrium model. Finding of the paper reveals that fiscal and monetary policy interacts with each other and with other macroeconomic variables. Inflation responds to fiscal policy shocks in the form of government spending, revenue and borrowing shocks. Monetary authority’s decisions are also affecting fiscal policy variables. It is also evident that fiscal discipline is critical for the effective formulation and execution of monetary policy.