This study models the relationship between budget deficit and trade deficit by using Autoregressive Distributed Lag (ARDL) and Dynamic Ordinary Least Square (DOLS) empirical estimation methods. The empirical results indicate that budget deficit leads to trade deficit in the long run, and it will stimulate it more in the coming years.

Pakistan's budget deficit was above the target of 4.7% of the GDP and current account deficit was around 8% of GDP (Pakistan Economic Survey 2007-08). With slower growth in industry and weak global demand conditions, the projected import growth would result in still larger trade deficit. Against this backdrop, the present empirical work attempts to determine the association between these two imbalances in Pakistan during the period 1971-2007. Econometric analysis is performed by employing the Autoregressive Distributed Lag (ARDL) approach to cointegration and the Dynamic Ordinary Least Square (DOLS) technique.

The rest of the paper is structured as follows: first, a theoretical explanation is given, followed by a review of relevant literature. Subsequently, the econometric methodology used in the paper is discussed, followed by the empirical findings. Finally, the conclusion is offered with policy implications.

The Mundell-Fleming model explains that increase in the government's budget deficit could lead to an increase in the trade deficit through increased consumer spending (Fleming, 1962; and Mundell, 1963). Furthermore, the Keynesian absorption theory argues that an increase in budget deficit would induce domestic absorption and therefore import expansion, causing a current account deficit.

Monetary Economics Journal, Budget Deficit, Trade Deficit, Pakistan Economy, Autoregressive Distributed Lag, Dynamic Ordinary Least Square, Mundell-Fleming Model, Current Account Deficit, Gross Domestic Product, ARDL Model, Error Correction Model, Robust Cointegration Techniques, Policy Implications, Agricultural Development, Natural Resource Development.