The aim of this study was to achieve three main objectives. Firstly to analyze the impact of budget deficit on macroeconomic variables, secondly to analyze the effect of domestic bank borrowing and external borrowing on budget deficit and thirdly to analyze the causality among the macroeconomic variables. Annual data for the sample period 1960-2005, taken from Economic Surveys of Pakistan and International Financial Statistics was used. Simultaneous equation model was used to investigate the mechanism through which the monetary and fiscal impulses were channeled and then their effects were transmitted to other macroeconomic variables. The effects of increase in money supply due to borrowing from domestic banking system and foreign borrowing to finance budget deficit were channeled through private and public investment to other macroeconomic variables. Linear regression model was used to analyze the effect of domestic borrowing and external borrowing on budget deficit. The Vector Autoregressive (VAR) model was used to analyze the causality among the macroeconomic variables, using the impulse response function (IRF) and the error variance decomposition analysis. The stationarity of the time series data was checked by using Augmented Dickey-Fuller (ADF) test. Akaike Information Criterion (AIC) was used to select the optimum lag. Johansen Likelihood Ratio (LR) test was used to ascertain the cointegration in the regressions used for analysis. Error Correction Mechanism (ECM) was used to analyze the existence of short term disequilibrium in the model. The study revealed that fiscal and monetary variables are important to determine the macroeconomic stability in Pakistan. The expansion in government capital expenditure through money supply for two cases (short term/long term) indicates that this policy in short term had no favorable impacts upon Pakistan economic development in terms of crowding-in effects. The rapidity of adjustment during the whole process towards long run steady state was very low. In the long-term this policy had favorable impacts on both private and public investment (crowding-in effects).The short-term and long-term policies both had favorable impact in terms of output development. It results in gain of better internal performance in terms of consumption expenditure, capital expenditure and balance of trade. In short-term domestic outputs adjust previous discrepancy in the same period, and had the capacity to gain competitiveness and a better external performance. The short-term policies for foreign sector were uncertain. A short-term result indicates that frequent devaluation will not improve trade balance but would increase the cost of production. The long-term policies had favorable impact in terms of foreign sector development. Income elasticity of export was less than the income elasticity of import. Instead of having favorable impact of devaluation on foreign sector in long-term, Pakistan trade balance deteriorated in line with deterioration in foreign assets stocks. The employment generating capacity of output growth was low. Budget deficit financing in terms of borrowing from domestic banking system and foreign borrowing had almost the same capability of financing budget deficit, but the financing elasticity of foreign borrowing with respect to budget deficit was greater than one, indicating that Pakistan relies mostly on foreign borrowing for deficit financing, which results in foreign reserve outflows. Any innovation of one standard deviation towards economic growth and budget deficit took seven years for each one to become effective, while for unemployment it took eight years and for poverty reduction it took more than ten years to become effective. The response of the four macroeconomic variables (Economic growth, budget deficit, unemployment, and poverty) to innovations or impulses introduced were mostly explained in their own. Only two unilateral causality were present, and mostly independent type relationships were detected. Based on the finding of the study it is recommended that government should give priority to long-term private/public investment policies, which can gain better results in economic growth, poverty alleviation and unemployment reduction. Export sector needs more attention in terms of quality standard, price control, and internationally adopted marketing strategies. Parallel and effective running of monetary, fiscal and exchange rate policies are needed to reduce balance of payment deficit. Market based economy development, privatization, skill development, and merit based recruitment policies may also accelerate employment generating capacity of output growth. The existing fiscal policy needs alteration in terms of objective achievement and prolonged channels towards implementation. Multidimensional fiscal policies with coordination of monetary policy will be appropriate to combat all the macroeconomic evils. Domestic sources of deficit financing should encourage to deter foreign reserve outflows. Three separate government policies in respect of budget deficit reduction indicates that the reduction in government expenditure (capital or consumption) exerts the most undesirable influence on the overall macroeconomic performance, and domestic source financing policy produces favorable impact compared to foreign borrowing financing. Hence, the reduction in government expenditure in order to reduce the budget deficit is not the best strategy and especially the policy of reducing government capital expenditure. The government expansionary monetary policy for budget deficit reduction would have some positive effects on Pakistan‘s economy, but the government has to be conscious about the inflationary effects of this policy.