Abstract
Asymmetries in fiscal policies cannot be captured by linear time series models. In order to examine the asymmetry responses of output in different phases of the business cycle, Markov Regime Switching (MRS) model is an alternative technique that is used to achieve the objective. The main objective of this study is to empirically explore the effects of fiscal shocks (spending and taxes) on Pakistan’s overall economic activity GDP while utilizing Markov Switching MS-VAR model. The model is characterized to allow for the variation in mean, coefficients and in error variances. The study results show that the effect of shocks and the size of multiplier varies across regimes confirming the asymmetric behavior of fiscal policy transmission mechanism. Moreover, the impact of positive spending shock has a stronger effect on output in the recession as compared to boom. One surprising result of the study is that the tax shock increases the output both in recession and boom. Lastly, spending and revenue behave a-cyclically.
 JEL Classification Codes: C11; C32; E62
Highlights
The monetary policy during the Great Recession reached its limits and was unable to answer the ongoing recession
The main objective of this study is to empirically explore the effects of fiscal shocks on Pakistan’s overall economic activity GDP while utilizing the Markov Switching MS-VAR model
The study results show that the effect of shocks and the size of multipliers vary across regimes confirming the asymmetric behavior of fiscal policy transmission mechanism
Summary
The monetary policy during the Great Recession reached its limits and was unable to answer the ongoing recession. The different theoretical models might explain the different effects of fiscal policy on aggregate economic activity at different times. This might be due to the asymmetric response of the economy to fiscal shocks as a result of whether the economy is in boom or recession. The effect of fiscal policy on private demand is a question in the academic literature of macroeconomics. Keynesian and Classical economists have different views regarding expansionary fiscal policy (Hoppner & Wesche, 2001). Keynesians believe that an increase in government expenditure positively affects private demand, which results in a “crowding-in” effect. Classical believes that when government finances expenditure through public debt, the public expects future taxes which induce the labor to increase supply and lower the real wages and consumption as well as aggregate economic activity
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