A Model for Forecasting and Policy Analysis in Pakistan: The Role of Government and External Sectors

This paper contributes to the development of the next generation of Forecasting and Policy Analysis System (FPAS) by formulating, estimating and conducting a forecast evaluation of a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model customized for Pakistan. The DSGE model in this paper contributes through addition of the detailed fiscal and external sectors of the economy. The fiscal block models the behavior of government expenditures, tax revenues and government debt, and allows for government borrowing from the central bank that affects monetary growth. Key additions to a conventional external sector block include the introduction of transaction costs in international borrowing and lending, which weaken the link between returns on domestic assets and the exchange rate adjusted returns on foreign assets. Further, to analyze the dynamics of major components of inflation, CPI is disaggregated in three components: core, food and oil inflation. Application of the model for alternative macroeconomic scenario assessment and forecasting is conducted likewise, especially regarding monetary policy formulation in Pakistan. Forecasts of major macroeconomic variables from this DSGE model are compared with those obtained using a comparable Bayesian VAR model and a DSGE-VAR model. New FPAS outperforms both Bayesian VAR and older generation FPAS model, as shown by the in-sample projection comparison regarding GDP growth, nominal interest rate and CPI, in a rolling window forecasting setup. In addition, the forecast efficacy of both DSGE VAR model and new FPAS model is quite comparable as they yield similar results.