Government Debt and Fixed Capital Formation Nexus: Effects of the Interest Rate and Monetary Policy Credibility Channels

Does the interest rate channel impact the relationship between the positive government loan debt to GDP ratio shock and capital formation in South Africa? The results indicate that positive government debt shocks crowd out capital formation. The findings of the crowding-out effects are robust to different model specifications and different ordering of variables in the model. Furthermore, the results show that gross fixed capital formation declines more due to large positive government debt shocks than to small-sized government debt shocks. The counterfactual model results indicate that the interest rate tightening channel amplifies the decline in capital formation due to positive government debt shocks. This contrasts with the effects of the interest rate loosening channel which mitigates the decline in capital formation due to positive government debt shocks. In addition, the monetary policy credibility channel mitigates the crowding-out effect of capital formation by positive government debt shock. Thus, high monetary policy credibility dampens the decline in capital formation due to positive government loan debt shocks. This is because monetary policy credibility contains the inflation risk component of the yield curve and results in predictable short-term interest rate changes. The policy implication of these results is that the interest rate loosening and high monetary policy credibility channels play an important role in neutralising the crowding-out effects of high government debt shocks on capital formation.