Impact of the Yield Spread on Economic Contraction in Pakistan: An Adverse Relationship

Abstract

The yield spread has a positive association with future economic expansion, up to a certain extent. An inverted yield curve is recognized as a potential indicator of economic contraction. This study aims to examine the impact of the yield spread, calculated as the difference between the weighted average rates of return on 5-year deposits and the 3-month rates of return, on the economy of Pakistan. To measure the contraction and expansion probabilities, Hamilton's (1989) Markov switching model is used. Afterwards, the impact of yield spread on economic contraction is analyzed by applying the ARDL bounds testing approach, based on 40 years of data ranging from 1980 to 2020. The findings indicate a positive association among the yield spread and the probability of contraction. Therefore, this study suggests that whenever there is an increase in yield spread, economic contraction rather than growth is expected. Whereas, control variables such as migration and foreign direct investment (FDI) reduce the chances of economic contraction. On the contrary, an increase in the price level increases its probability.