Crowding-out Hypothesis in a Vector Error Correction Framework: A Case Study of Pakistan

Kalim Hyder


Under the umbrella of the IMF stabilisation programmes,
Pakistan has pursued a policy of fiscal consolidation since 1988. A look
at the budget deficit from 1988 onwards reveals that the policy has only
been marginally successful. Even this fragile accomplishment of the
Fund-based programme has been achieved at a much greater cost: the
reduction in budget deficit has only been materialised because of the
curtailment of development expenditure component of total fiscal outlays
[Social Policy and Development Centre (2001)]. Economic theory suggests
that development expenditure component of fiscal outlays, which also
equals net investment by the public sector,1 has a significant
relationship with both the rate of private investment and economic
growth. If public investment increases, fewer funds will be available
for private investment. Competition will thereby drive the interest
rates up leading to lower level of private investment. Neo-classicals
believe that this process will only result in a redistribution of gross
national between the public and the private sector and the rate of
economic growth will remain intact. On the other hand, Keynesians argue
that the multiplier effect of higher public spending will be larger as
compared to the induced negative effect of reduced private investment on
the rate of economic activity and, therefore, gross national product
will increase.

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