Do fiscal shocks explain bond yield in high- and low-debt economies?

Abstract

PurposeThe purpose of this study is to investigate how the uncertainty associated with fiscal policy, i.e. government expenditure and tax revenues, can affect the interest rates in a group of eleven countries, comprising high- and low-debt countries: Cyprus, Greece, Ireland, Italy, Portugal, Spain, Australia, Canada, Denmark, New Zealand and Norway.Design/methodology/approachThe empirical analysis makes use of the structural VAR (SVAR) methodological approach, which allows us to decompose the effects of the contribution of shocks generated by each variable, as well as their transmission effects.FindingsThe empirical findings suggest that both demand and supply factors influence interest rates across their frequency spectrum. For the majority of high-debt countries, the course of the yields on their government bonds is driven mainly by supply side factors and not demand (i.e. government expenses or taxes) factors.Research limitations/implicationsGiven that the economies of certain (mostly small) countries are affected by economic conditions in large countries, especially when they have large capital flows or trade much with these countries, the future empirical analysis could also consider both domestic and international (control) macroeconomic variables to explain the course of interest rates due to fiscal changes.Originality/valueThe previous literature does not capture the financial crisis period, nor does it take a comparative approach – high debt versus low debt – to investigate the effect of fiscal shocks on interest rates. Thus, we aim to respond to the following questions: (1) How do fiscal shocks affect interest rates in the sample of selected countries? (2) How different is the impact of fiscal shocks on interest rates in high- and low-debt countries?