BUDGET DEFICITS, PUBLIC SPENDING AND INTEREST RATES IN THAILAND

Abstract

Beginning in 1987, Thailand experienced lower real interest rates, an investment boom, and rapid economic growth. We investigate whether these lower real rates were caused by conservative fiscal policy. Using data from the years 1980–94, we test between the Keynesian theory that smaller budget deficits reduce real interest rates and the Neoclassical theory that lower government spending reduces those rates. We find support for the Neoclassical model. Cuts in both consumption and construction expenditures appear to lower real interest rates. Surprisingly, lower public equipment spending appears to raise real interest rates. We attribute this to three factors. First, equipment spending could significantly boost aggregate supply. Second, public equipment spending is somewhat countercyclical, which could generate a spurious negative correlation with procyclical real interest rates. Third, public equipment spending appears highly correlated with government net foreign borrowing, which would relieve pressure on interest rates to rise. The results imply that controlling public spending is crucial for maintaining low real interest rates, but also that prudent public sector investment partially externally financed need not raise real interest rates and could effectively promote domestic capital formation.