Anticipated Budget Deficits and the Term Structure of Interest Rates

This paper investigates the implications of government deficits in an overlapping generations consumption loan model with longterm assets. The only asset in the economy is a real consol issued by the government and serviced by lumpsum taxes on the young. We explore here the time path of short and longterm interest rates following the announcement of a future,transitory budget deficit under two alternative assumptions. In one case the deficit arises from transitory government spending, in the other case from a transfer.We show that a deficit policy ultimately raises longterm interest rates and lowers consol prices. The exact shape of the path of short-term rates depends on the source of the deficit and on the saving response to interestrates. In general, though, the term structure will be v-shaped. The interest of the model resides in the fact that the prices of longterm assets link the current generations to future disturbances. Because future disturbances affect future interest rates they affect the current value of debt outstanding and hence equilibrium short-term rates. The exact manner in which the disturbances are transmitted to prior periods depends on the extent to which consumers substitute easily across time or, on the contrary, have a strong preference for consumption smoothing.