ABSTRACT

Keynesian theories of the post Great Depression era turned  orthodox classical understanding of the economy  over  its head.  Governments, since  then, have actively used  fiscal  policy for managing demand — maintaining surpluses in boom and  deficits  in recessions.   With  time, fiscal  policy has evolved more as a tool  of economic  management though  deficit  spending than  being  limited to managing crisis.    Fiscal deficits,  therefore,  continue  to be relatively  com- mon compared to surpluses and  thus importance of a government’s ability to finance  these deficits  then  cannot  be overstated.    These  deficits  are financed mainly through two  avenues:   central  bank  and  private  banks.   The  choice  of the avenue,  over  the years,  have  attracted  much  debate  due  to its  intended consequences  for major  economic  variables such  as employment, output,  in- flation  etc.  Economists have  been convinced for quite some time that govern- ment borrowing through central bank  is damaging from the economy  because it erodes fiscal discipline, encourages political business cycles and causes infla- tion  money  creation  but,  borrowing from  private  banks  is seen as a resource transfer  where  no new  money  gets created  and  interest  rate serves  both as a market  measure  of discipline and  control.   This  view  led  to the central  bank independence movement  of the 70s curbing government ability to pressuring banks  into  financing excessive  spending.  In  some  cases,  this  movement  has shown   promising results  by  bringing  inflation down  and  output  up  but,  in other cases there have  also been mixed or negative results.   Pakistan has also recently  passed  the law  that makes  it central  bank  autonomous and  therefore not bound  to finance government’s deficit.

Government has in the past borrowed money  both from the central bank as well  as private  banks  to cover deficits.  The intent of this study  is to investigate whether it makes any difference in terms of direction and magnitude for output and inflation whether government borrows from central bank or private  banks?

Our  analysis shows  that, it makes  little to no difference  in impact  of inflation or output  as far as the choice of the borrowing source  is concerned.  What our results  elude  to is that for a developing economy  such  as Pakistan, making a central bank  autonomous may  not provide the benefits that are intended  from this  legislation rather  may  prove  to be a hurdle in  managing possible  future crisis  by the government by restricting essential financing.