Linear and Non-Linear Effects of Fiscal Deficit on Inflation in Pakistan: A Test of the Fiscal Theory of the Price Level

Abstract

The study conducts an empirical analysis of the asymmetric short-run and long-run effects of fiscal deficits on inflation in Pakistan within the framework of the Fiscal Theory of the Price Level (FTPL).  The study uses annual time-series data for the period 1960-2024 and employs linear auto-regressive distributed lag (ARDL) and nonlinear ARDL (NARDL) models to estimate the fiscal deficit–inflation nexus, capturing dynamic and asymmetric adjustments.  Inflation is the dependent variable, while fiscal balance, exchange rate, unemployment rate, current account balance, interest rate, debt-to-GDP ratio, oil price, trade deficit, and broad money supply are chosen as independent variables representing fiscal and monetary variables. When the fiscal deficit is high, inflation will happen. So, the proposition of the FTPL holds true. A rise in the exchange rate and the oil price further augments inflation, while fiscal discipline, efficient debt management, and proper interest rate policy help stabilise prices. The findings highlight that persistent fiscal imbalances, compounded by external shocks, weaken the effectiveness of monetary policy.