Terms-of-Trade Shocks, External Adjustments and Growth in Pakistan: How Much to Sacrifice

Pakistan is largely considered as having balance of payments constrained economy. These constraints become more intense when external shocks hit, such as unfavorable changes in the country’s external terms-of-trade. In this paper, we attempt to document the cost to the economy when sailing through such shocks. Empirical estimates show substantial external adjustment takes place after the terms-of-trade bust in case of Pakistan. These adjustments largely work through income effect as the role of expenditure switching effect is estimated to be lower, though overtime increasing. Our main finding is about the cost to the domestic output when such shocks hit, which we call a sacrifice ratio. We find this impact is quite large, albeit decreasing overtime. We also find that the role of exchange rate policy is an important determinant of how large that sacrifice ratio will be. From the policy perspective, including monetary policy, these are important findings as they provide insights to policymakers about choices they can make during the stress times.