Fiscal Policy and Interest Rates

Abstract

Since the Seventies, increases in public debt and deficits have raised concern about their effects on interest rates. Growing public debt and persistent deficits would have led to inflation pressures, which would have forced central Banks to raise the short-term interest rate. Expectations of these pressures by financial markets would involve a rise in long-term interest rates and crowding-out effects. This paper studies the fiscal policy effects on interest rates from a theoretical and empirical point of view. Fiscal policy effects mainly depend on the full-employment hypothesis, the type of shocks affecting the economy, the type of fiscal policy, and agents' expectations about it. The estimated effects of fiscal policy variables in central Banks' reaction functions and long-term interest rate equations for the United States, the United Kingdom, Germany and Japan for the 1980-2003 period show that these effects are not mechanical and vary from one country to another. All in all, fiscal policies would not have entailed a generalized increase in real interest rates over that period.