Macroeconomic Impacts of External Shocks on Economy: Recursive Vector Autoregressive (RVAR) Analysis

Abstract

This study examines the short run analysis of external shocks impact on Pakistan’s economy. We applied the Recursive Vector Autoregressive (RVAR) methodology using the monthly data over the period 2001M1 to 2016M12. We examine impact of external shocks like oil price shocks and foreign interest rate shocks on the macro variables of Pakistan economy. These macro variables include inflation rate, output, interest rate, money supply and real effective exchange rate. We also analyze the transmission channels of these external shocks on domestic economy. Then we applied impulse response function on both external shocks (oil price and foreign interest rate). These impulse response functions concluded that oil price shocks have inflationary pressure on Pakistan economy while foreign interest rate shocks have minor impact on Pakistani macroeconomic variables except real effective exchange rate. According to impulse response function analysis, when oil price shock arises inflation immediately increases while the foreign interest rate shocks have no serious effects on domestic macroeconomic variables. However, the changes in foreign rate of interest have effect on real effective exchange rate. On the basis of generalized impulse response function, our findings are supported by generalized forecast error variance decompositions analysis. This decomposition analysis clearly supporting the impulse response functions that revealed that oil price shocks have inflationary impact on Pakistan economy while foreign interest rate changes have minor impact on domestic variables. However, real effective exchange rate is majorly affected by foreign interest rate. In sum up, these external shocks are strengthening the stagflation in Pakistan. Policy makers should make viable policy to cope this problem and take into account these shocks during policy making. To minimize the Oil price shocks inflationary pressures on the economy, we should focus on alternative renewable sources of energy sector like solar plant.