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Do Budget Deficits Raise Interest Rates? A Survey of the Empirical Literature

  • Leanne Ussher

    ()

    (Department of Economics and BBA, Queens College of the City University of New York)

Do government budget deficits raise interest rates and thus “crowd out” private investment? This question has been the topic of a multitude of empirical studies, which proposed to evaluate the impact of financing government activity. We survey the theory and some empirical results. Traditional theories either support deficits having a positive or a neutral effect on interest rates. Various tests of these propositions yield diverse results, and one can find all conclusions – that deficits raise, decrease or do not effect interest rates. Also, there is little attempt to ground their assumption that rising interest rates result in a crowding out of private borrowing and investment. The problem with many of the empirical studies begins with their narrow theoretical underpinnings which are driven by assumptions of resource constraints, exogenous money supply, or government budget constraints. Alternatively, models that derive their economics from the demand side determining supply, have a transmission mechanisms missing from traditional models that may explain econometric testing incongruities. Such models take account of multi-asset markets, investment accelerators and consider the alternative causality - interest rates to budget deficits. They emphasize financial market instruments, investor behavior, and the relationship between the treasury and the central bank in determining fiscal and monetary policy. As a result, such models provide a richer understanding to the interaction between deficits and interest rates in their institutional setting.

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Paper provided by Department of Economics, Queens College of the City University of New York in its series Working Papers with number 0005 Classification- JEL:.

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Length: 39 pages
Date of creation: Apr 1998
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Handle: RePEc:quc:wpaper:0005
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