This study analyzes Pakistan’s external and internal debt situations on the basis of a three-gap model in order to make future projections of the indicators of deficits, borrowings and debts for the next 30 years and simulate the effects of various policy changes on these projected indicators. The study finds that deficits and debt situations have improved substantially during the past 10 years following large inflows of foreign exchange through formal channels after the event of 9/11. However, in the recent years the inflow of foreign exchange has mainly been used to raise the value of rupee against the US dollar. This drive has helped reduce inflation rate but at the cost of stagnant foreign exchange holdings and, hence, losing the opportunity of retiring some of the expensive short-term debt and avoiding the need for further borrowings. During the past 10 years, the borrowings levels have remained low but with increased year to year variation, the possible reasons being commodity price hike in the world market, oil price fluctuations, unprecedented increase in remittance, volatile capital movements due to changing law and order situation and changes of political regimes. The recent trend in borrowing and debts also indicate a tendency towards the substitution of external debt by internal debt, mainly caused by a sharp increase in unrequited transfers (mostly remittances). The study finds that the current account external and budget deficits are expected to continue increasing in future, thereby resulting in increased need to borrow externally as well as internally. The volume of external debt as a percentage of the GDP is expected to rise at relatively faster rates, whereas internal debt as a percentage of the GDP is expected to remain stable around. The study concludes that the benefits of foreign exchange inflow following the 9/11 event are not going to last any longer and Pakistan will have to search for more permanent solutions to its continuing problem of managing the fiscal and balance of payments situations. Further, on the basis of simulation analysis the study confirms the presence of debt-growth trade-off and concludes the key to bypass the trade-of is productivity as represented by capital-output ratio. Any policies that aim to improve productivity are likely to produce the desirable result, that is, reduction in debt burden without growth sacrifice or increase in growth rate without added burden of debt. Thus all such measures that improve economic efficiency, human capital, knowledge, overall governance structure, general law-and-order situation and political stability are likely to bring fruitful results. Since these policies also need investment of resources it is important to conduct benefit-cost analysis of alternative ways of improving productivity and their feasibility Supervisor: Prof. Eatzaz Ahmad