Regime Switches in Pakistan’s Fiscal Policy: Markov-Switching VAR Approach
Author: Wajid Ali

The literature demonstrates that business cycle asymmetries is not accurately captured by linear models and Markov regime switching (MRS) provides an alternative technique that is used to identify business cycle asymmetries, and is also flexible to examine different relationship in business cycle phases. This study uses Markov Switching MS-VAR with Time Varying Transition Probability (TVTP) to empirically explore the effects of fiscal shocks (spending and Taxes) on Pakistan’s overall economic activity (GDP). The study uses quarterly data1 from 1973 to 2014 of fiscal instruments and GDP for the estimation of different specifications of MS-VAR models with TVTP and Constant Transition Probability (CTP) among which the best fit model with four regimes is chosen for analysis. This model allows for variation in mean, coefficients and in error variances. The fluctuation in business cycles in Pakistan’s economy is captured by using the State Bank of Pakistan’s policy rate as informational (leading indicator) variable. Based on the historical data and structural changes, study identifies four regimes early 1980, late 1988, 2000 and early 2010. The results show that a positive shock to government spending increases output in second and fourth regime while it decreases output in first and third regime. The response of output to tax shock in most cases is insignificant and negative except regime 4, in which output increases due to one unit tax shock until 10th quarter and then become insignificant due to inelastic nature of tax to GDP ratio. Fiscal shock crowd out private investment in first and third regime while the phenomena of crowding-in is observed in second and fourth regimes. Lastly, twin deficit is observed in all regimes. Supervisor: Dr. Abdul Sattar

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Keywords : Economic Activity, Fiscal Policy, MSVAR Model, Nonlinear Effect
Supervisor: Abdul Sattar

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