Fiscal Policy Uncertainty and Economic Growth in Pakistan: Role of Financial Development Indicators

By Farooq, Ateeqa; Yasmin, Bushra | Journal of Economic Cooperation & Development, January 1, 2017 | Go to article overview

Fiscal Policy Uncertainty and Economic Growth in Pakistan: Role of Financial Development Indicators


Farooq, Ateeqa, Yasmin, Bushra, Journal of Economic Cooperation & Development


(ProQuest: ... denotes formulae omitted.)

1.Introduction

The importance of stable and predictable macroeconomic policies for a prosperous and sustainable economic growth has long been realized by the developing countries. Economic analysts accused economic uncertainty as one of the major cause of low economic growth of these economies. Pastor and Veronesi (2012) argued that the bad economic news creates uncertainty over the future government policies which results in immediate decline in investment and economic growth. Theoretically, the influence of economic uncertainty laid down its channel through marginal productivity theory where marginal productivity of capital is convex to particular uncertain variable and penetrates into the behavior of investment. Therefore, macro-economic uncertainty modifies the expected net value of marginal product of capital and ultimately contributes to changes in economic growth. Such investment behavior held responsible to generate economic uncertainty in foregoing and future predictability, as well. The support to the role of policy uncertainty in economic growth also comes from the line of literature by Lucas and Prescott (1971), Arrow (1968) and Caballero (1991). Hence, the economic uncertainty is an integral part of decision making which is precisely inclined to the investment decisions and renders strong implications for the economic growth.

The experience of developing countries in 1960s and 1970s highlighted the role of macroeconomic instability as fundamental in shattering economic growth. It also connotes the great recession that witnessed low economic recovery due to economic uncertainty (Baker et. al, 2012). The proclaimed instability has also become prevalent in Pakistan and its origin is reflected in different macro-economic policy indicators. This instability, inherited by macro-economic uncertainty, has its roots in the economic structure and development indicators. It is well argued that impact of monetary and fiscal policy is intensified in the presence of economic uncertainties and gets reflected in terms of lower economic growth mainly due to backward and unpredictable behavior of investment (Bernanke, 1983; Pindyck and Solimano, 1993 and Dixit and Pindyck, 1994).

The fiscal policy uncertainty is very critical in this regards. According to Chaudhry and Shabbir (2005), economic uncertainty is demonstrated in worsened fiscal policy in terms of budget uncertainty as the uncertain budget imposes restrictions and distributive risks for the subsequent fiscal years. Pakistan, Govt. of (2010) proclaimed that the economy of Pakistan has perennial budget uncertainty rolls from 2.3% to 1.9% in 1980s and fell from 3% in 1990s to 1.6% in 2000, due to rescheduling of debt services, a very upshot of uncertain budget.

Similarly, the uncertainty in revenue collection imparts irreversible investment and has long run consequences for economic growth (Atif, Shahab and Mehmood, 2012). The upheavals in political scene and IMF conditionality reinforce revenue generation uncertainty in Pakistan to 0.8% and 0.4% in 1980s and 1990s, respectively. Ultimately, the optimality of government expenditures is desirable for sustainable fiscal conditions. The conventional fiscal policy in Pakistan has subdued persistently by uncertain government expenditures as one of the failures of fiscal policy entailment. The uncertain government expenditures are expected to have negative shock on the economic growth and endeavors to the rising tax liabilities in near future. Precisely, such instabilities are more likely to prevail in the developing countries as reported by Kneller et.al. (1998).

Herewith, the role of financial sector pertains to the economic growth of the country. According to Aghion et al., (1999), since the financial sectors are less developed in developing countries these economies suffer more from volatility. The signaling behavior of financial development enriched with capital market perfections can issue equity under economic uncertainty and hence absorb the likely risks. …

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