Academic journal article Pakistan Economic and Social Review

MACROECONOMIC INSTABILITY AND ITS IMPACT ON GROSS DOMESTIC PRODUCT - an Empirical Analysis of Pakistan

Academic journal article Pakistan Economic and Social Review

MACROECONOMIC INSTABILITY AND ITS IMPACT ON GROSS DOMESTIC PRODUCT - an Empirical Analysis of Pakistan

Article excerpt

Byline: AMJAD ALI and HAFEEZ UR REHMAN

Abstract

This study tries to answer the question, "has macroeconomic instability detrimental impact on gross domestic product of Pakistan over the period of 1980 to 2012?" For reviewing macroeconomic instability a comprehensive macroeconomic instability index is constructed by incorporating inflation rate, unemployment rate, trade deficit and budget deficit. Autoregressive Distributed Lag (ARDL) model has been used for examining the cointegration among the variables of the models and Vector Error-Correction model is used for short-run dynamics of the models. For investigating the causal relationship among the variables of the model Granger causality test has been applied. The empirical results of the study confirm the existence of cointegration between macroeconomic instability and gross domestic product in Pakistan.

The results of the study show that macroeconomic instability has deep rooted and detrimental impact on gross domestic product of Pakistan. Hence, for achieving desired level of gross domestic product, Pakistan should make macroeconomic environment stable.

Keywords: Macroeconomic instability, Gross domestic product, Financial development, Secondary education, Foreign direct investment

I. INTRODUCTION

The basic challenge for economics is to understand the nature and causes of economic progress. Ricardo (1817) refers that the total goods and services produced in a country are the best scale to know economic progress. The economy is like a machine which transforms inputs to outputs and the amount of inputs determines the amount of outputs. After World War II, most of the countries adopted aggressive economic policies to improve the growth rate of real gross domestic product (Crafts, 2000). Exogenous technological progress and accumulation of factors of production are considered to be main determinants of economic growth. Solow (1956) explains that with physical inputs there are some nonphysical (skill, knowledge) factors which determine steady state economic growth. Nelson and Phelps (1966) suggest that size and capability of labour absorb new technology which is discovered elsewhere.

But the last decade of 20th century has changed the direction of research about economic growth when Lucas (1988), Romer (1990) and Grossman and Helpman (1991) developed endogenous growth theory.

The policymakers and economists are much interested in sustainable level of economic growth and are much worried in downward movement of economic growth. Barro (1991), Baker (1998) and Caballero (2007) mention that internal and external factors are responsible for instable economic progress. There are three main sources of instable gross domestic product in developing countries like Pakistan. First, big exogenous shocks which come from financial markets and terms of trade. Second, less developed nations experience domestic shocks due to intrinsic instability and self-inflicted policy faults (Kharroubi, 2006). Lucas (1988), Barro (1991) and Kraay and Ventura (2007) explain that the specialization of developing countries with traditional technologies and unskilled labour make the output of these countries more volatile. Raddatz (2007) finds that domestic shocks in developing nations are more forceful for creating macroeconomic instability as compared to external shocks.

Third and the most important factor is that the underdeveloped nations have weak shock absorption capacity (De Ferranti and Ferreira, 2000).

The economy of Pakistan has been facing external and internal shocks throughout its history but the magnitude of these shocks has become severe after 9/11. The downward and unsustainable trend of economic progress in Pakistan has made the policymakers and economists worried. In Pakistan fiscal deficit, high inflation, political instability, lack of human and physical capital, increasing foreign debt, low exchange rate, natural disasters and unfavourable law and order conditions for investments are responsible for instable economic progress. …

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