Fiscal Policy and the Term Structure of Interest Rates

Abstract

Macroeconomists want to understand the effects of fiscal policy on interest rates, while financial economists look for the factors that drive the dynamics of the yield curve. To shed light on both issues, we present an empirical macrofinance model that combines a no-arbitrage affine term structure model with a set of structural restrictions that allow us to identify fiscal policy shocks, and trace the effects of these shocks on the prices of bonds of different maturities. Compared to a standard VAR, this approach has the advantage of incorporating the information embedded in a large cross-section of bond prices. Moreover, the pricing equations provide new ways to assess the model's ability to capture risk preferences and expectations. Our results suggest that government deficits affect long term interest rates, at least temporarily: (i) a one percentage point increase in the deficit to GDP ratio increases the 10-year rate by 35 basis points after 3 years; (ii) this increase is partly due to higher expected spot rates, and partly due to higher risk premia on long term bonds; and (iii) the fiscal policy shocks account for up to 13% of the variance of forecast errors in bond yields.JEL: E0, G0 * We are grateful to Roberto Perotti for sharing his programs with us.

Term structure modelling with observable state variables

“…The parameter estimates for the MV model are reported on Panel B of Table 4. The findings are in line with previous results in that economic activity and inflation drive the level factor (as in Evans and Marshall, 1996), economic activity (as in DRA) and monetary policy (as in Evans and Marshall, 1996;Piazzesi, 2005) drive the slope, and fiscal policy drives the curvature factor, consistent with findings of Dai and Philippon (2005). Note, however, the performance of the model in terms of MAE is very similar to the SV model.…”

“…Finally, following Dai and Philippon's (2005) finding that fiscal policy affects the term structure, I introduce the variable DEBT, which is their quarterly fiscal policy variable interpolated to the monthly frequency and divided by INDPRO, a proxy variable for GDP at the monthly frequency. Panel A in Table 2 summarizes the macroeconomic variables used.…”

“…The investigation of the variable DEBT in a number of specifications comes from recent evidence that fiscal policy does play a role at explaining the curvature factor of the term structure (Dai and Philippon, 2005). However, the fact that specifications with UR instead of DEBT as drivers of the curvature factor seems to be robust (in particular, compare specifications 30 and 33).…”

Macroeconomics and the Term Structure

“…Dai and Thomas Philippon (2005) consider an affine model with a measure of fiscal policy as an element of the state vector, which provides a clear channel for bond supply to affect yields.…”

Money and asset prices in a continuous-time Lucas and Stokey cash-in-advance economy

“…3 Walsh (2003) provides a useful discussion of the micro-foundations of the NKMM model, while Clarida et al (1999) review the issues related to different monetary policy rules. 4 Some recent working papers have investigated the link between monetary and fiscal policy rules and asset prices, namely, the term structure of interest rates; for example, see Ho¨rdahl et al (2003), Rudebusch and Wu (2003), Dai and Philippon (2004), Ang et al (2005), Beckaert et al (2005), Bikbov and Chernov (2005), and Gallmeyer et al (2005). NKMM with a CIA constraint and a cash and credit goods distinction.…”