Fiscal deficit and inflation: New evidences from Pakistan using a bounds testing approach

•The paper investigates the relationship between fiscal deficit and inflation.•The article finds fiscal deficit is a major determinant of the price level.•The findings suggest that the economy requires corrections of fiscal imbalances.

Leeper (1991), Sims (1994) and Woodford (2001) point out that price level is not independently determined by monetary policy rather it is the result of inter dependence of fiscal and monetary policies. This article aims to test the fiscal theory of price level for Pakistan using an autoregressive distributed lag model framework over the period of 1972-2012. The article finds that fiscal deficit is a major determinant of the price level along with other variables like interest rates, government sector borrowing and private borrowing. On the basis of our findings, the present article suggests that the economy of Pakistan requires an immediate correction of fiscal imbalances.