Testing the Fiscal Theory of Price Level in Case of Pakistan

Abstract

The study tests the fiscal theory of price determination for Pakistan’s economy for the period 1970 to 2007. The evidence is less clear cut to infer that authorities are following a certain type of regime fiscal dominant or monetary dominant during the sample period. The liabilities responses negatively to the innovation in surpluses, that is in the subsequent period the liabilities decreases in face of increase in surplus. This characterises monetary dominant regime, the events that give rise to surplus innovation are likely to persist causing the rise in the future surpluses and surpluses pay-off some of the debt causing the fall in the liabilities. By analysing the behaviour of nominal GDP, an innovation in surplus reduces nominal income and decreases the level of debt in the subsequent periods, this analysis also confirms the Ricardian analysis. On the other hand, the study finds that, as predicted by the fiscal theory of price determination, the occurrence of wealth effects of changes in nominal public debt may pass through to prices by increasing inflation variability in case of Pakistan. The implication that comes out of this study is that nominal public liabilities, as reflected either in money growth or in nominal public debt, matter for price stability in case of Pakistan. The authorities may be following different regimes for different time periods during the 1970-2007.Fiscal Theory of Price Level, VAR, Fiscal Policy, Monetary Policy