Fiscal Imbalances and Inflation: A Case Study of Pakistan

Deficits are a feature of any economy and more so of a developing economy due to the urge of investing for future growth. In case of Pakistan, it has been observed that in recent years inflation has crossed the threshold point and fiscal imbalances have been the most important factor in contributing towards inflation. This paper focuses on relationship between fiscal deficit and inflation and how financing fiscal deficit affects inflation. To investigate this correlation, a long run data of Pakistan starting from Fiscal year 1976 to Fiscal year 2007 has been analyzed. Different modes of financing fiscal deficit have been observed which include deficit financing, financing through external borrowings and internal borrowings. The empirical findings of the study indicate that there exists a positive relation between fiscal deficit and inflation. All the modes of financing deficit are positively and significantly related to inflation in Pakistan. This has been empirically tested by applying co integration test. The results imply that deficit financing is the most inflationary mode of financing fiscal deficit.