Inter-Dependencies in Budget Deficit and its Financing Sources in Pakistan (1960-2005)

The paper critically appraises causality, susceptibility to innovation of budget deficit, domestic borrowing from banking system and foreign borrowing. Secondary data is used, which was taken from annual Economic Survey of Pakistan (various issues), and International Financial Statistics (2005). For analysis, Vector Autoregressive (VAR) model with Impulse Response Function (IRF), Error Variance Decomposition and Granger Causality test is used. The study revealed that any innovation of one standard deviation took seven years for budget deficit and more than ten years for domestic bank borrowing and foreign borrowing to be effective. The variation in budget deficit is mostly explained by itself. Most of the variation in domestic bank borrowing is explained by budget deficit, while variation in foreign borrowing is mostly explained by budget deficit and domestic bank borrowing. Two unilateral causality are found and no bilateral causality, and in mostly independent relationships have been detected. Based on the finding the study suggests parallel and harmonized fiscal and monetary policy to reduce foreign reserves outflow. Fiscal policy is more vulnerable to shocks or innovations and monetary policy took longer time to become effective, so the gap between monetary policy formation and its implementation must be reduced.