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In this thesis we argue the fiscal and monetary policy coordination can be best served to achieve broad macroeconomic goals. We argue that in a developing country like Pakistan distributional efficiency is more important than overall technical efficiency. Therefore, the broad macroeconomic goals considered in this thesis reducing poverty, increasing labor and capital productivity, reducing disparity between regions and communities, creating job opportunities for skilled labor force, to keep inflation low and stable etc.. According to UN Inter Agency Assessment during June-July 2008 found that food security is significantly worsened as a result of food price hike; some 45 million people in 2008 affected by this food price hike. Due to this food price hike Pakistan economic survey reports around 6 percentage point's increase in poverty incidence (Pakistan, Government of, 2007-08). In the 2010-11 a devastating flood in Pakistan affect 20 Million people and majority of the poor in Pakistan lives in flood affected areas. Similarly, United Nations Human development report 2010 reported that between 1980 and 2010 Pakistan's HDI is increasing very slowly just 1.5% annually from 0.311 to 0.490 in 2010. Pakistan was placed at 125th rank out of 169 countries. The HDI of South Asia increased from 0.315 in 1980 to 0.516 in 2010, placing Pakistan below the regional average, and the rate of increase in HDI is lower than the average growth rate in comparable south Asia region. According to a recent report it is claimed that the state of education in the country is extremely worrying: we are second in the global ranking of out-of-school children, with seven million not attending primary school and three million who will never see the inside of a classroom (DAWN 10th March 2011).
In a democratic society parliament takes decision according to the preference of the people and it should be reflected in their financial planning i.e. in annual budget or in longer period plan for example five-year plan. These kinds of planning and expenditure decision are part of fiscal policy. In a developing country markets are not competitive; differentiated labor productivity poor investment opportunities and strong feudal system prohibits market forces to properly work. The private sector can not investing in the areas where they think their profits are low, therefore the government must take their due attention for the development of these lacking areas and reduce their poverty. Only a pro-active fiscal policy is a viable route for getting out of the vicious circle of poverty at mass level.
The father of macroeconomics Keynes was in favour of fiscal policy to recover an economy from stagnation or deep depression. He argued that fiscal policy could be used to create jobs and incomes (Mukherjee, 2007). Before Keynes it was assumed that government spending and taxation were powerless in altering aggregate level of economy and hence employment (Blinder & Solow, 1973). In the Keynesian model prices are assumed to be not changing and economy has excess un-utilized capacity. The aggregate output is determined by aggregate demand. If government increases a rupee expenditure it will produce greater than one rupee increase in aggregate spending because private consumption also depends on current income (spending), this will create multiplier effect in the economy and an expansionary fiscal policy can accelerate effective demand and create more jobs. Keynes argued that monetary policy would be relatively ineffective compared to fiscal policy because saving and investments are less sensitive to interest rate. Therefore mere lowering the interest rate does not stimulate investment. Investment primarily determined by the profit expectations of the private businesses.
Milton Friedman a major proponent of monetary policy rejected the idea of using fiscal policy for stabilizing economy. The Friedman lag doctrine rejected the role of fiscal policy in improving economic stability. Friedman distinguishes three types of lags. First recognition lag, the action lag and the effect lag. The recognition lag is the time lag between when an actual economic shock, such as sudden boom or bust occurs, the action lag is a part of the implementation lag involving the time it takes for appropriate policies to be launched and the effect lag is the amount of time between the time action is taken and an effect is realized. These lags actually reduce the impact of fiscal policy on the economy and further create random disturbances and therefore further destabilize economy (Snowdon 2005). In Friedman's view people adjust their private consumption on the basis of their permanent Income. In this permanent income hypothesis people base their consumption decision on what they consider their permanent (normal) income; a temporary rise in the income does not increase their consumption behavior. They tend to maintain their living standards throughout their life smoothly. Therefore a temporary increase in their income does not alter the consumption spending, and does not create multiplier effect. Further, private investment is sensitive to interest rate. The monetary policy can effectively use to contain interest rate. Increased money supply decrease interest rates, and since private investment is sensitive to interest rate therefore this increase aggregate spending in the economy. Friedman also argued monetary policy is far more stable and powerful than Keynes suggests (Friedman, 1957). Monetary policy could be implemented relatively quickly and less costly; although, their effects are also subject to long outside lags. He suggest for rule base monetary policy instead of discretionary fiscal policy.
New classical economists mainly emphasized on; a) the rational expectations hypothesis; b) the assumption of continuous market clearing; and c) the Lucas ('surprise') aggregate supply hypothesis. New Classical economists argued that expansionary fiscal policy (higher government expenditure or lowering tax rates) essentially increases budget deficit and accumulates public debt. The rational household understands increasing debt must be paid by future higher taxes. This argument is based on government inter temporal budget constraint and sustainability and solvency issue of fiscal deficit. These future taxes leads to lower their future income, therefore they save today to protect lowering real income future. This increased saving thus lower their today's consumption and leads to reduce aggregate spending (Gwartney, 2008). To New classical economists debt financing is mere a lowering today's taxes for the future higher taxes, and thus does not alter household wealth and increased private consumption. The continuous market clearing hypothesis ensures there is no involuntary unemployment, labor market always clear and labor demand is exactly equal to the labor supply. Their analysis leaves no room at all for involuntary unemployment.
New Keynesian give much importance as compare to there predecessors old Keynesian on the role of monetary policy in stabilizing the economic fluctuations, while there is no unified new Keynesians view on the role of fiscal policy. Most of the New Keynesian recognizes the importance of government actions where market failure occurs. For example, Taylor (Taylor 2000) argues in favor of discretionary fiscal policy to achieve long-term economic growth, whereas for business cycle fluctuations adjustment monetary policy is more effective and automatic stabilizers of the fiscal policy should play their role. Most new Keynesians also accept the Friedman critiques on the fiscal policy effectiveness related to future uncertainty, presence of long lags (identification lags, administrative lags and operational lags) and the potential to create political business cycles.
The New Neoclassical Synthesis(NNS) incorporates classical features such as a real business cycle (RBC), rational expectations hypothesis, costly price adjustment and Keynesian features such as imperfect competition in goods, labour and credit markets, and nominal rigidities (see Lucas, 1987; Goodfriend 2002; Snowdon 2005). In this NNS the emphasis were more on monetary policy. The rule base monetary policy framework, and importance of central bank independence emphasized. The consensus has been emerge on monetary policy has persistent effects on real variables due to gradual price adjustments, and a little long run tradeoff between real and nominal variables. Inflation has a significant welfare costs due to its distorting impact on economic performance. To contain inflation credibility of policy is also emphasized. The fiscal policy does not have major role in stabilizing economic fluctuations, it is considered as a subservient to monetary policy.
Post-Keynesian reject the idea of new classical that a capitalist economy automatically tended towards full employment. Post-Keynesians are in favour of government fiscal policy to achieve long run economic growth. Post-Keynesian express the need for fiscal policy via Abba Lerner's "functional finance" approach (Tcherneva, 2010). Pavlina R. Tcherneva argued for the two distinct approaches to functional finance. First, is to increase aggregate demand and close the GDP gap and the second is to secure full employment through direct job creation. Abba Lerner argued that government policy should not be judged by the size of the deficit but by the impact it has on the economy (Lerner 1943). He also explained that how governments faced no limits on its spending and argued that it was the role of the fiscal authorities to spend as much as it was necessary to bring the economy to full employment. Post-Keynesian distinguish two specific types of functional finance; one argues that the primary objective of fiscal policy is to secure full employment via a universal job guarantee. The other supports injecting as much aggregate demand as necessary to close the output gap by creating additional effective demand but without an explicit guarantee to provide jobs for all (Tcherneva, 2010). Tcherneva's view Arestis and Sawyer made the case for fiscal policy via functional finance, where the task of government policy specifically is to secure high levels of aggregate demand, when private demand is deficient (Arestis and Sawyer 2003). Functional Finance via Aggregate Demand (FFAD) argued flawed notions about the federal deficit leave aggregate demand in a too restrictive instance (Eisner 2003, Eisner 1986, Colander and Matthews 2006), budgets are mere accounting identities taxing and spending must be adjusted in an anti-cyclical manner with a focus on their economic impacts. Tcherneva's view Arestis and Sawyer explicitly made the case for fiscal policy via functional finance, where the task of government policy specifically is to secure high levels of aggregate demand, where private demand is deficient (Arestis and Sawyer 2003). Keynes's public works are the examples of Functional Finance via Direct Job Creation. The government should act as an employer of last resort (ELR). The ELR proposal as it is discussed in the work of Hyman Minsky (Minsky 1986, Mitchell 1998 and Wray 1998). What is new in this approach is that it makes an explicit link between guaranteeing employment and government finance (see Mosler 1997-98).
Historically economists are not agreed upon a particular policy to stabilize economic fluctuations and stimulate long run growth. In the golden era starting from 1950's and till 1970's most of the developed and developing countries uses Keynesian perspective and fiscal policy is a major driving force for economic growth and full employment and it was constitutional obligation of the government to maintain full employment. The monetary policy takes back seat. In 1970's when globally inflation was rises, the Keynesian economic solutions were challenged. The stagflation (low growth with high inflation) hit most of the developed world. The cure was found in the monetary policy solution to stabilization of the economy. The monetary policy sits on the steering and fiscal policy takes back seat. Fixed money growth rate rule, interest rate targeting and inflation targeting were major policy options. The more weight was given to inflation stabilization and fewer roles to decreasing unemployment were given using monetary policy. The most of the developed world's central bank are now following the role based and inflation targeting approach.
Since the start of new millennium a renewed focus is started on the role of fiscal policy due to various shocks felt in various part of the globe. In the 1987 stock market all around the developed world crashed significantly. The financial turmoil of 1997 In East Asian economies, and recent US subprime mortgage crisis 2007-2009 put renewed focus on the role of fiscal policy at difficult time. Most of the developed and developing countries announced huge fiscal stimulus packages to restore the economic situation in their respective countries.
The concept of fiscal and monetary policy mix is well-understood in the macroeconomics literature. Keynesian and post Keynesian are in favour of fiscal policies should be considered to stimulate economy both in short run and in the long run, and monetary policy should be subservient to the ministry of finance. The monetarist, new classical and most of the new Keynesian are in favour of that monetary policy should be required to play major role in economic stabilization as well as long run stability and fiscal policy works in subservient of monetary policy. The greater coordination of fiscal and monetary policy is accepted by most of the policy makers. Policy is coordinated when the ministry of finance (treasury) and the central bank (State bank of Pakistan) joined forces to maximize social welfare. Although the objectives of both fiscal and monetary policy would be same as to achieve stable and non-inflationary long run equitable economic growth. Lack of coordination will make a suboptimal outcome inevitable. Blinder argues that why in reality some times monetary and fiscal policies are not coordinated. He pointed out three causes. First the monetary and fiscal policy may perceive differently about what is better for the society (they may have different objectives). Second they argue differently for the use various fiscal and monetary policy instruments. Third they may have different view of state of the economy in the absence of policy interventions. They may have different forecasting models. The crucial question of lack coordination one may ask who should determine the actual targets; the people sitting in the ministry of finance or the people sitting in the State bank of Pakistan. The potential gains from the coordination of fiscal policy have been traditionally analyzed using the Tinbergen and Theil (See Tinbergen 1952, 1956 and Theil 1964) framework of targets and instruments approach. Tinbergen and Theil approach suggests that to achieve an equilibrium solution one should have as many instruments as targets are. These instruments may includes monetary policy instruments, such as a monetary aggregates or the central bank controlled interest rate (discount rate in Pakistan), or fiscal policy instruments, such as the level of government spending or tax rates controlled by the ministry of finance. For example (See Blinder 1982) targets for stabilization policy might be the level of current output (GDP), the inflation rate, and the new capital formation. The fiscal instruments are government spending (current and development) and the tax rate (tax to GDP ratio), then need a perfectly coordinated monetary policy to achieve above targets.
In this thesis we will seek to develop a theoretical framework for this purpose. We argue for dominating role of fiscal policy, the reason is that fiscal policy traditionally made by parliamentarians. In the democratic society, these parliamentarians are elected through voting systems. The politicians understand better their territories. They can use a prudent fiscal measure to approach an equitable long-term growth. We do not endorse William Nordhaus view on political business cycles that suggests politicians may actually use economic policy for their own benefits. If people believe on them there is no reason we do not trust on them. To avoid any kind of one government attempts to influence the policies of future governments by manipulating the debt; we may find some rule that put some kind of check and balance on politician. For discussion on various kind of restriction see (Mohsin 1991), (Buiter 2001) and (Aristis 2006). The emphasis should be on real stability and long-term sustainable, equitable growth and a balance between market and government: since markets are essentially imperfect, government interventions are necessary (Stiglitz & Ocampo, 2006). Stiglitz argued that most of the macroeconomics development was in industrialized countries, although the basic macroeconomic goals and identities are same but the behavior of the macroeconomic agents firms, households, and governments are different. The developing countries have various macroeconomic imbalances. Accesses to basic facilities (primary enrollment, primary health care, income generation capacity etc) are not available in most of developing countries. Although, various form of Aid is available, but still developing countries are far behind the level that exist in any of the industrialized country (See World Development Report, Human Development Report).
A Post-Keynesian approach of functional finance is most appropriate for a developing country like Pakistan. In the Lerner's functional finance approach fiscal policy was to be judged not by ex-post budgetary results, but by its real effects on the economy (Lerner 1943). The traditional view of government tax cut creates fiscal deficit increases government debt, financing of government borrowing reduces national saving and crowding out private capital accumulation (Mankiw 2001). This view is already rejected by the Ricardian equivalence hypothesis. According to Ricardian equivalence debt financed tax cut does not change consumer's behavior of increased consumption. Since consumers are in the Ricardian world forward looking they understand today's tax cut will necessarily increase taxes in future. Therefore they save extra disposable income that increases private saving and this exactly equal to government dis-savings and national saving will remains unchanged. This means fiscal policy is ineffective in changing consumer behavior. In response to ineffectiveness of fiscal policy Woodford's argues (Woodford 1995) that an independent central bank tight monetary policy is not sufficient to guarantee price stability. Price stabilization requires a combination of fiscal and monetary policy. This view is also controversial, but it gives an open door to issue of coordination between fiscal policy and monetary policy.
In this thesis we argue the fiscal and monetary policy coordination can be best served to achieve broad macroeconomic goal.
Hypothesis to be investigated
Does various government provided funds decrease the poverty level in the period studied?
Does government social sector expenditure increase the productivity of labor force?
Does government economic development expenditure sufficiently increased the capital formation in the economy?
Do various tax incentives improve income equality in various regions?
Does differentiated interest rate (long run financing rate) improves sector wise equality in growth.
Does credit planning to various sectors successfully answer the issue of inequality?
Methodology and data
In order to assess the strength of monetary as well as fiscal policy responses due to a various shock as well as comparing it with the response, preferably we should estimate a complete structural macroeconomic model. A structural model explains the relationship between economic variables using theoretical knowledge or using a priori knowledge. The structural model may have several arbitrary restrictions' on the coefficients of the variables. These restrictions on the model may inhibit us revising the model even when such a need legitimate. The VAR approach sidesteps the need for structural modeling by treating every variable as endogenous in the system as a function of the lagged values of all endogenous variables in the system. The term autoregressive is due to the appearance of the lagged values of the endogenous variable on the right-hand side and the term vector is due to the fact that a vector of two (or more) variables is included in the system model.
The mathematical representation of a VAR system is
Where Yt is a 'k' vector of endogenous variables, Xt is a 'd' vector of exogenous variables, A1, â€¦, Ap and B are matrices of coefficients to be estimated, and et is a vector of innovations that may be contemporaneously correlated but is uncorrelated with both its own lagged values along with all of the right-hand side variables.
Since only lagged values of all (endogenous) variables appear on the right- hand side of the equations, problems of simultaneity are avoided. In this case, Ordinary Least- Squares (OLS) yields consistent estimates. Moreover, even though the innovations may be contemporaneously correlated, OLS is efficient and equivalent to Generalized Least Squares (GLS) because all of the estimated equations in the system have the same right-hand side variables.
The advantages of VAR include; the method is simple, one does not have to worry about determining which variables are endogenous and which ones exogenous. All variables in VAR are endogenous. Estimation is simple; the usual OLS method can be applied to each equation separately. Some problems with VAR modeling are; a VAR model is a-theoretic because it uses less prior information. In the simultaneous equation models exclusion or inclusion of certain variables plays a crucial role in the identification of the model. The individual coefficients in the estimated VAR models are often difficult to interpret; the practitioners of this technique often estimate so-called impulse response functions. The impulse response functions trace the response of the dependent variable in the VAR system to shocks in the error terms, and traces out the impact of such shocks for several periods in the future.
If cointegrating relations are present in a system of variables, the VAR form is not convenient. In that case it is useful to consider specific parameterizations that support the analysis of the cointegrating structure.
A practical feature of cointegrated variables is that their time paths are influenced by the extent of the deviation from long run equilibrium. If the system is to return to equilibrium, the movement of at least some of the variables must respond to the magnitude of the disequilibrium. Thus, having identified the vector either, exactly identified or over-identified, a natural step is to examine the short-term dynamics influenced by temporary deviations from a long run relationship. This is done by formulating the relationship in terms of Vector Error Correction Modeling (VECM). The VECM seeks to uncover the propagation mechanism underlying the behavior of the dynamics under consideration or to indicate the direction of the Granger (temporal) causality. VECM also allow us to find out the causal factors that affect our variables. If cointegration is present, the short-run Granger-causality relationship is then analyzed using VECM framework, to avoid the problem of misspecification (see Granger 1988)  . Otherwise, the analysis may be conducted on the basis of standard VAR model  . The direction of Granger-causal effect running from one variable to another can be detected using the VECM derived from the long-run cointegrating vectors. Besides the detection of the short-run causal effects, the VECM also allows us to examine the effective adjustment towards equilibrium in the long run through the significance or otherwise of the t-test of the lagged ECT of the equation.
Toda and Yamamoto (1995), Rambaldi and Doran (1996) and Zapata and Rambaldi (1997), argued method for detecting causality such as ECM and VECM are cumbersome and sensitive to the values of the nuisance parameters  in finite samples and hence, the results are unreliable. In addition, pre-tests are necessary to determine the number of unit roots and the cointegrating ranks before proceeding to estimate a VECM. The Granger non-causality test suggested by Toda and Yamamoto (1995) offers a simple procedure requiring the estimation of an 'augmented' VAR model in a straightforward way, which is based on the Modified Wald (MWALD) test statistic for testing linear restriction on the parameters. Therefore, the Toda-Yamamoto causality procedure has been labeled as long run causality tests. All one needs to do is to determine the maximal order of integration dmax that expect the model to incorporate and ascertain the lag structure, and then to construct a VAR with variables appearing in their levels with a total of p = (k + dmax) lags. However, at the inference stage, linear or nonlinear restrictions should only be tested on the first k lags since the p - k lags are assumed zero and ignored. Toda and Yamamoto point out that, for d = 1, the lag selection procedure is always valid since k â‰¥ 1 = d. If d = 2, then the procedure is valid unless k =1. Moreover, according to Toda and Yamamoto, the MWALD statistic is valid regardless whether a series is non-cointegrated or cointegrated of an arbitrary order. Rambaldi and Doran (1996) have demonstrated that the MWALD procedure for testing Granger non-causality can be easily constructed using a Seemingly Unrelated Regression (SUR). In this thesis we would use the Todo-Yamamoto (1995) modified version of the Granger causality test, which has an advantage of handling non-stationary variables.
The frequency of time-series data used in this thesis will generally annually. The State bank of Pakistan compiled various economic series since 1950  , this is the only compiled data available at one place. This data is available online at State Bank of Pakistan website (see http://www.sbp.org.pk). Other government agencies also published their annual reports, occasional reports, surveys that may be used for official data. The data wee need to analyzed above mentioned hypothesis on the following variables
Gross domestic Product
Human Development Index
Regional inequality index
Total Government expenditure
Total Tax revenue
Foreign Aid (Assistance )
Social Sector expenditure
Economic Development expenditure
Credit creation in various economic sectors