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.