Dynamics Of Deficit Financing, GDP And Inflation: An Evidence From Pakistan Economy

Abstract

The primary economic policy objectives for any country are fostering GDP growth and controlling inflation. However, economies across the globe face resource limitations and budget constraints in achieving these goals. In the repercussion of the global financial crisis and the COVID-19 pandemic, fiscal deficits have shown an upward trend in many countries, including Pakistan. Notably, from 1991 to 2022, Pakistan has not recorded a single fiscal year with a balanced or surplus budget. During this period, the average fiscal deficit stood at 5.93% of GDP, average debt servicing at 7.13% of GDP, and the average current account deficit at 2.48% of GDP. Meanwhile, the average Consumer Price Index (CPI) inflation was 9.11%, and average GDP growth hovered around 4.24%.

In the long run, a country's economic output is determined by its productive capacity, which depends, in part, on its capital stock. Persistent fiscal deficits can reduce investment, slowing the progress of capital stock and ultimately diminishing the economy's capacity to produce goods and services (Ball & Mankiw, 1995). These deficits are typically financed through seigniorage, domestic borrowing, and external borrowing, each having varied impacts on macroeconomic indicators such as GDP growth and inflation (Easterly & Schmidt-Hebbel, 1993).

To explore these dynamics, this study employs time series data from 1976 to 2023 and applies the ARDL bounds testing model to examine both the short-run and long-run relationships between deficit financing and key policy variables—GDP growth and inflation. The ARDL model is selected due to the mixed order of integration among the variables.

The findings reveal that both external and domestic borrowing have a significant and positive effect on GDP growth in the long and short run. Interestingly, while external and domestic borrowings also exert a significant and positive effect on inflation, seigniorage demonstrates a negative and statistically insignificant relationship with inflation. Additionally, control variables interest rate, exchange rate, investment, and total public debt are found to significantly influence both GDP growth and inflation.

These results underscore the importance of a disciplined fiscal policy framework that promotes economic growth without triggering inflationary pressures. The paper recommends a shift toward more sustainable financing options, such as improved tax mobilization, rationalized public expenditures, and reliance on non-inflationary sources of funding. The study adds to the existing literature on fiscal policy dynamics in developing economies and offers relevant policy implications for Pakistan’s long-term macroeconomic planning.