The linkage between fiscal deficit and real interest rate: Theory and empirical evidence
Under the neoclassical perspective the theory of interest rate determination is postulated under saving- investment equality in the market of loanable funds. Increased government borrowing increases the demand for loanable funds and thus leads to greater competition for the limited pool of domestic saving (determined by full employment level of income) thereby bidding up interest rates and reducing private investment, holding all else constant. However such a claim is suspect in a demand constrained economy which is operating well below the full employment level.
In Keynesian theory, the interest rates are determined by the portfolio allocation in the Bond-Money market and a government deficit will lead to an increase in the stock of bonds. With money supply held fixed, the agents will demand a higher interest rate in order to hold this more bonds in their portfolio. These rising interest rates will feed back into the goods market to dampen investment and output. However, with increased government spending or falling taxes, there will also be an income multiplier which will increase income and savings and thus demand for financial assets. As bond demand rises, the initial interest rate rise should be mitigated. However, the transaction money demand will also rise and, as money supply is fixed, a further rise in interest rate is required. Thus overall, the effect on interest rate would be unambiguous and would depend a great deal on the income elasticity of money demand, interest elasticity of real output, interest elasticity of money demand. Also the endogenous money supply theories shall not support such evidence. Also, in an open economy model with perfect capital mobility, demand for bonds is infinitely sensitive to interest (as government bonds are close substitutes for other international financial assets). Thus domestic deficits cannot raise interest rates above world interest rates.
Under the view of Ricardian Equivalence Hypothesis, an exogenous increase in bond demand can stem from the tax-fearing agents. The individuals believe that all government spending must be financed by taxation either now or sometime in the future. Thus, to them a government deficit is simply deferred taxation. Therefore, agents will increase savings and buy the government bonds in order to hedge their future tax payment (i.e the taxes raised to pay back the bonds). This exogenous increase in bond demand perfectly matches the exogenous increase in bond supply by the government and neither interest rates nor the consumption path of individuals will change.
Therefore while several strands of literature posit an increase in the interest rate following the rising levels of fiscal deficits, their underlying assumptions make them suspect. Thus we need to look at some existing empirical evidence on the issue of linkage between fiscal deficit and real interest rate.
The alleged impact of government deficits on an economy contain mixed empirical evidence. However substantial literature exists on the neutral or even insignificant impact of fiscal deficit on interest rates. U.S. Treasury Department (1984) demonstrated that deficits do not impact either short-term rates or long-term rates, “Deficits have at most a negligible effect on raising real interest rates” (Department, 1984). Motley (1983) regressed real yields on three-month T-bills on federal deficit and found no significant impact. Evans (1985) conducted a 2SLS and found an insignificant or negative relationship between interest and real deficits. Dua and Arora (1988) demonstrated that expectations of fiscal deficits have no effect on interest rates. Barro and Sala-i-Martin (1990) regress world average expected short-term interest rates on world deficits and debt and found deficits and debt to be insignificant. They also regressed investment on deficits and concluded that deficits/debts do not change investment by much.
Department, U. T. (1984). The Effect of Deficits on Prices of Financial Assets: Theory. Washington, DC: U.S. Government Printing Office.
Dua, P., & Arora, H. (1989). Do Expected Budget Deficits Affect Household Expectations of interest rates. journal of macroeconomics , 11 (4), 551-62.
Evans, P. (1985). Do Large Deficits Product High Interest Rates? American Economic Review , 75, 68-87.
Motley, B. (1983). Real Interest Rates, Money and Government Deficits. Federal Reserve Bank of San Francisco Quarterly Review , 31-45.
Sala-i-Martin, & Barro, R. (1990). World Real Interest Rates. (O. Blanchard, & S. Fischer, Eds.) NBER Macroeconomics Annual 1990 , 5, 15-74.
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