Fiscal Policy and Interest Rates

Abstract

Since the Seventies, increases in public debt and deficits have raised concern about their effects on interest rates. Growing public debt and persistent deficits would have led to inflation pressures, which would have forced central Banks to raise the short-term interest rate. Expectations of these pressures by financial markets would involve a rise in long-term interest rates and crowding-out effects. This paper studies the fiscal policy effects on interest rates from a theoretical and empirical point of view. Fiscal policy effects mainly depend on the full-employment hypothesis, the type of shocks affecting the economy, the type of fiscal policy, and agents' expectations about it. The estimated effects of fiscal policy variables in central Banks' reaction functions and long-term interest rate equations for the United States, the United Kingdom, Germany and Japan for the 1980-2003 period show that these effects are not mechanical and vary from one country to another. All in all, fiscal policies would not have entailed a generalized increase in real interest rates over that period.

Explaining the US bond yield conundrum

“…12 Accordingly, the term structure is going to flatten with higher and to steepen with lower short-term rates (see also Diebold et al, 2006). The less than proportional response of i l to i s in the US has also been detected by Ducoudré (2005). The overall impact of the business cycle, measured by ism, on i l is positive, indicating that the effect via the supply of bonds is dominating (in line with Diebold et al, 2006).…”

The Impact of Transparency on the Cost of Sovereign Debt in Times of Economic Crisis

“…On the other, there is the assets markets approach, where the supply and demand for government securities determine the market yield. Ducoudré () adds other theories of fiscal policy‐interest rates links: the expectation theory of the term structure of interest rates and the neoclassical growth model.…”

“…All this literature does not find a significant relationship between fiscal balance and interest rates. Finally, Ducoudré () shows that fiscal policy has no mechanical effect on interest rates but its effects depend on the policy‐mix, and on the economy's regime.…”

“…On the other, there is the assets markets approach, where the supply and demand for government securities determine the market yield. Ducoudré (2005) adds other theories of fiscal policy-interest rates links: the expectation theory of the term structure of interest rates and the neoclassical growth model. Hoelscher (1986) shows that although the relationship between deficits and short-term interest rates may be tenuous, there is strong evidence that larger deficits are associated with higher long-term interest rates.…”

Russian Fiscal Policy During the Financial Crisis

“…Fiscal expansion may only be effective if it is not followed by monetary tightening. The tightening may result from crowding out by increased government demand, either in the money markets via a rise in interest rates in connection with deficit financing, or in the goods and services markets (see Ducoudré (2005)). This however will occur only if the money supply is kept constant during the fiscal expansion.…”