Relationship between Budget Deficit and Money Demand in Pakistan: An ARDL Approach

Abstract

A highly debated issue in developing world is persistence of budget deficit. There have been some theories of fiscal policy to analyze the association between accelerating budget deficit and macroeconomic performance. Major harmful effects of it are increase in high rate of interest, low savings, low growth rates, large current account deficit. The objective of this study is to explore the relationship between these two variables for the case of Pakistan. ARDL approach to cointegration is applied to check the causality between these two major variables along with many other important macroeconomic variables incorporated in money demand function. Data used spans from 19702009. Findings of the empirical analysis verify the implications of Keynesians theory in Pakistan and rejection of Ricardian Equivalence Hypothesis(REH). Results show that there exists short run and long run relationship between budget deficit and money demand. And 1percent increase in LDEF leads to approximately 0.013percent increase in LM1. This stability of money demand function has many policy implications 
for monetary and financial authorities.