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Fiscal Policy and the Term Structure of Interest Rates

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  • Qiang Dai
  • Thomas Philippon

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 macro-finance 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 (i) government deficits affect long term interest rates: a one percentage point increase in the deficit to GDP ratio, lasting for 3 years, will eventually increase the 10-year rate by 40--50 basis points; (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 12% of the variance of forecast errors in bond yields.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11574.

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Date of creation: Aug 2005
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Handle: RePEc:nbr:nberwo:11574

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  1. GlennD. Rudebusch & Tao Wu, 2008. "A Macro-Finance Model of the Term Structure, Monetary Policy and the Economy," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 118(530), pages 906-926, 07.
  2. Douglas W. Elmendorf & N. Gregory Mankiw, 1998. "Government Debt," Harvard Institute of Economic Research Working Papers, Harvard - Institute of Economic Research 1820, Harvard - Institute of Economic Research.
  3. Eric M. Engen & R. Glenn Hubbard, 2004. "Federal Government Debt and Interest Rates," NBER Working Papers 10681, National Bureau of Economic Research, Inc.
  4. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, American Finance Association, vol. 57(1), pages 405-443, 02.
  5. N. Gregory Mankiw, 1999. "The Savers-Spenders Theory of Fiscal Policy," Harvard Institute of Economic Research Working Papers, Harvard - Institute of Economic Research 1888, Harvard - Institute of Economic Research.
  6. Thomas Laubach, 2009. "New Evidence on the Interest Rate Effects of Budget Deficits and Debt," Journal of the European Economic Association, MIT Press, MIT Press, vol. 7(4), pages 858-885, 06.
  7. Hördahl, Peter & Tristani, Oreste & Vestin, David, 2004. "A joint econometric model of macroeconomic and term structure dynamics," Working Paper Series, European Central Bank 0405, European Central Bank.
  8. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(4), pages 745-787, May.
  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  10. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  11. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "Should the European Central Bank and the Federal Reserve be concerned about fiscal policy?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, pages 333-389.
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