Fiscal Policy Transmission and Inflation Dynamics: Insights from DSGE Model
Abstract
This paper investigates the transmission mechanisms of fiscal policy and their effects on inflation dynamics using a medium-scale Dynamic Stochastic General Equilibrium (DSGE) model. The model integrates nominal rigidities (sticky prices and wages), forward-looking expectations, and a government sector that includes consumption, investment, taxation, and public debt dynamics. Researcher estimated the model for Pakistan using data source as World Development Indicators from 1990 to 2024, then simulated unanticipated fiscal shocks including increases in government consumption, public investment, and tax cuts, and trace their impulse responses for output, inflation, the output gap, interest rates, and debt over time. Results highlight several key findings. First, government consumption shocks generate a strong demand effect and lead to a temporary increase in inflation, which is constrained by monetary policy responses and resource constraints. Second, public investment shocks exert a less inflationary effect, due to their partial supply-side benefit over the medium run. Third, tax cuts tend to have inflationary consequences that depend on the structure of tax changes (e.g., consumption vs. income taxes). Fourth, the magnitude and persistence of inflation responses are highly sensitive to the degree of price and wage stickiness, the credibility of the fiscal framework, and the reaction function of monetary policy. Finally, in periods where monetary policy is constrained (e.g., at the zero lower bound); fiscal expansions have more pronounced inflationary impacts. The findings suggest that monetary–fiscal coordination is essential to stabilize inflation while achieving output stabilization. They also imply that public investment may be a more inflation–friendly component of fiscal stimulus compared to pure consumption spending. ARDL approach, Bound test with some diagnostic test will be employed in this analysis.
Keywords: Fiscal Policy, Inflation Dynamics, DSGE Model, Time Series Analysis, ARDL Model, Co-Integration
