Understanding Business Cycle Fluctuations in Pakistan

Gulzar Khan, Ather Maqsood Ahmed

Abstract


Notwithstanding the level of improvement in understanding the
complexities of an economy, it is now well accepted that the ultimate
incidence of various policy interventions leads to varied outcomes in
terms of magnitude and persistence depending upon the structure of the
economy. The objective of the present study is to disentangle the
relative contributions of various exogenous and domestic shocks that
contribute to business cycle fluctuations in Pakistan. The study is
based on the New-Keynesian Open economy model, which is an extended
version of (Gali & Monacili 2005). Keating’s two-step approach
(1990, 2000) is employed to capture the dynamic behaviour of the
variables of interest. Impulse response functions, along with forecast
error variance decomposition analyses, are used to gain useful insights
into the understanding of the transmission mechanism of policy and
non-policy shocks. It is observed that fiscal policy does matter, at
least in the short-run. The interest rate shock leads to the exchange
rate appreciation thereby confirming the exchange rate puzzle. In
response to adverse supply shocks, the Monetary Authority responds with
a monetary contraction that prolongs the recessionary periods.
Furthermore, it has a limited power to control inflation as inflation in
Pakistan stems from supply-side factors as well as fiscal dominance. JEL
Classification: C32, E52, E62, F41 Keywords: Open Economy, New Keynesian
Model, Rational Expectations, Exchange Rate Puzzle

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DOI: https://doi.org/10.30541/v59i1pp.1-28

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