Fiscal deficit and its impact on inflation, Causality and Co-integration: The Experience of Pakistan (1960-2010)

The main objective of this paper is to examine the impact of fiscal deficit on inflation. The fiscal deficit in Pakistan continues to deteriorate and pose risks for sustainability of growth in the longer time horizon. This paper reexamines the issue in the light of broader data and such modeling approach which incorporates the key features of the theory. The paper establishes that within sample, inflation in Pakistan is mainly attributed to unsustainable fiscal deficit. The question whether fiscal deficit generates inflation in long term prespective or otherwise, Cointegration and Granger-causality test are employed. Secondary data from 1960 to 2010 show a strong relationship between fiscal deficit and inflation. Growth in deficits, whether measured by amounts or by deficit-output ratios, positively Granger causes inflation. So this study concluded that fiscal deficit displayed a powerful effect on inflation in Pakistan and there is need of coordination between monetary and fiscal policy to curb the inflation. From Engel-Granger cointegration test there exist a long run relationship between BD [budget deficit] and CPI [consumer price index].