Policies Misalignment in Pakistan: Implications for Output Gaps

Abstract

Objective: Adjusting macroeconomic, monetary, and fiscal policies to maximize growth requires reliable production gap estimates. This research aims to determine sector-wise output gaps and their impact on macroeconomic production gaps.

Research Gap: In macroeconomics aggregate and static macro models are common but this type of modeling is inadequate due to macroeconomic aggregation assumptions and implied static interactions. Therefore, the inability to accurately model the output gap and growth trajectories miscalculates the policy projections leading to deviations between policy and its implementation. Insufficient technical integration of diverse policies and aggregative politically directed actions that do not match economic reality complicate policy misalignment. This study uses a detailed disaggregated examination of Pakistan's economy to increase empirical econometric knowledge of these gaps.

Design/Methodology/Approach: This study estimates sector wise potential output and output gap to assess policies’ effectiveness across different sectors of the economy. The study employs Autoregressive Distributed Lag (ARDL) Model to estimate potential output at the aggregate level and for subsectors of the economy.

The Main Findings: We find a strong correlation between the growth rates of potential output in industry and services sectors at the aggregate level while the correlation with the agriculture sector is the weakest. Shocks in aggregate economic activity adversely impact industrial sector, followed by the services sector. However, the agriculture sector is least affected by these shocks. In case of monetary policy shocks, agricultural output is insensitive to interest rate, while industrial and service sector output gaps are significantly affected. Contrary to this, impact of fiscal policy shocks impact on output gaps of all three sectors is insignificant.

Theoretical/Practical Implications of the Findings: It is observed that the policy is confronted with a dilemma specifically demand management policies are limiting the potential growth of output in Pakistan. There is need to focus on supply side of sectors and policy reorientation towards stimulation of investments.