Summary

Fiscal policy is essential to regulate the performance of the economy, avoiding macroeconomic imbalances and achieving full growth potential. As a core component of government policy, fiscal policy focuses on taxation, public spending, and government borrowing. The primary objectives of fiscal policy are the provision of public services, the promotion of investment in public goods, the equitable distribution of wealth, economic growth, inflation, the balance of payments and ensuring economic stability. Effective fiscal policy is also required not to negatively affect consumption and investment decisions and ultimately economic growth through the level and structure of taxes. Fiscal policy has an advantage over monetary policy due to its direct impact on the generation of employment opportunities and the reduction in income inequality. Furthermore, in times of economic recession or liquidity trap when monetary policy fails to stimulate economic activities, the initiation of fiscal intervention as a stabilization tool is inevitable and impactful.

The main objective of this thesis is to examine the impact of fiscal policy in the context of Pakistan’s economy. The central theme of this research revolves around three distinct, yet inter- connected aspects concerning the effectiveness of fiscal policy. The first two essays adopt the New Keynesian modeling approach, addressing two different scenarios: a small open economy and a liquidity trap. The key advantage of using this approach is the diagnosis of policy implications and the way the corrective policy measures affect the variables of interest. This thesis further contributes by using the more realistic assumption of bounded rationality in the first two essays. Bounded rationality provides an intuitive analysis that how the economic agents make economic decisions in the scenarios of small open economy and liquidity trap, when they are unable to per- ceive the true economic conditions and also fail to make optimal decisions in the finite planning horizons. In the third essay, an empirical analysis is carried out to check the efficacy of fiscal policy in Pakistan, considering the debt dynamics in the country. This analysis confirms that debt dynam- ics take on a pivotal role in the implications of fiscal policy as a counter-cyclical stabilization tool and in mitigation of economic downturns and recessions. This dissertation thoroughly examines the implications of fiscal policy in both the closed and the open economy scenarios within the context of the Pakistan economy.

The first essay introduces a micro-economic framework based small open economy model. The basic structure of the first essay is built around the assumption that economic agents do not possess perfect knowledge and fail to make optimal decisions. The assumption of rationality has been criticized for its failure to account for agents’ ability to make optimal decisions over an infinite time horizon. Particularly, when agents are considering new stabilization policies, the assumption of optimality is considered too stringent, especially within a finite time horizon (Woodford, 2013). Therefore, it is more practical and realistic to structure economic literature on the assumption of cognitive limitations and bounded rationality. Accordingly, the first essay incorporates the scenario of small open economy assuming that agents are boundedly rational and make economic decisions within a finite planning horizon. However, they also give priority to their financial status at the end of their planning horizon. The results of this essay offer a more comprehensive analysis, showing that an upturn in government spending becomes the cause of an expansion in economic output. The increase in this productivity consequently results in a reduction in both inflation and interest rates. Furthermore, the rise in government spending triggers a decrease in exchange rate and a decline in terms of trade. Conversely, an increase in consumption taxes and labor taxes results in a reduction in output and rise in inflation and interest rates. The analysis also affirms the existence of bounded rationality among the agents owing to which they fail to properly ascertain the economic situations. Accordingly, the impact of fiscal policy intervention becomes more pronounced in the shorter planning horizons than that of the longer planning horizon.

In the second essay, we uphold the concept of bounded rationality and explore the conse- quences of fiscal policy in the context of a liquidity trap. The theoretical and empirical literature provides evidence that in situations of extremely low inflation and interest rate, monetary policy fails to restore economic development and to bring the economy out of recession. Ultimately, the eventual implementation of fiscal policy interventions becomes imperative to stabilize the econ- omy, promote its recovery, and mitigate the impact of recession. The theoretical framework of second essay is the modified version of the one used in the first essay. The theoretical framework is developed for a closed economy under liquidity trap. Furthermore, the analysis is enriched by assuming that the agents have heterogenous expectations about inflation and output. More pre- cisely, a portion of these agents adopts a backward-looking approach, while the remaining fraction adopts a forward-looking perspective about the economic conditions. The analysis conducts three different scenarios of liquidity trap as first, fundamental driven liquidity trap, second, expectations driven liquidity trap and third, a mixed liquidity trap. The results of this essay confirm that in absence of fiscal policy intervention, (i) the fundamental driven liquidity trap ends the economy into deflationary spiral and, (ii) the expectations driven liquidity trap pushes the economy into longer periods of recession. Similar outcomes are obtained when there is a greater proportion of backward looking agents in the economy. Nonetheless in all scenarios of liquidity trap, fiscal intervention through increased government expenditure and a reduction in consumption taxes effectively pre- vents deflationary spirals. The results of this essay further confirms that the boost in government spending stimulates both output and inflation, offering a solution to exit the liquidity trap while a reduction in consumption taxes also exerts a positive influence on both output and inflation. Con- versely, a labor tax cut falls short in stimulating output and inflation, and, even exacerbate the risk of a deflationary spiral in the economy. This essay makes a valuable contribution to the fiscal literature of Pakistan by evaluating the efficacy of fiscal policy in the scenario of liquidity trap.

In the third essay, an empirical analysis is conducted to estimate the influence of fiscal policy in Pakistan. The relationship between debt and fiscal imbalances in Pakistan exhibits an inverse correlation that adversely impacts fiscal sustainability. The government’s revenue and expendi- ture play a pivotal role in managing debt on the other hand debt dynamics also play role in the government expenditure and revenue determination. Consequently, the levels of debt have intense implications over the influence of fiscal policy on Pakistan’s economy, similar to other developing nations. The empirical analysis is conducted following the methodology described by Favero and Giavazzi, 2007 and the SVAR identification strategy formulated by Blanchard and Perotti, 2002. This comprehensive essay maintains a keen focus on debt dynamics while assessing fiscal shocks and their eventual fiscal policy implications. This analysis confirms that an expansion in govern- ment spending has a positively significant and stimulating impact on output, whereas the influence of taxes on output is statistically insignificant and tends to bring a decline in output.