Fiscal Policy and the Term Structure of Interest Rates

Abstract

Macroeconomists want to understand the effects of fiscal policy on interest rates, while financial economists look for the factors that drive the dynamics of the yield curve. To shed light on both issues, we present an empirical macrofinance model that combines a no-arbitrage affine term structure model with a set of structural restrictions that allow us to identify fiscal policy shocks, and trace the effects of these shocks on the prices of bonds of different maturities. Compared to a standard VAR, this approach has the advantage of incorporating the information embedded in a large cross-section of bond prices. Moreover, the pricing equations provide new ways to assess the model’s ability to capture risk preferences and expectations. Our results suggest that government deficits affect long term interest rates, at least temporarily: (i) a one percentage point increase in the deficit to GDP ratio increases the 10-year rate by 35 basis points after 3 years; (ii) this increase is partly due to higher expected spot rates, and partly due to higher risk premia on long term bonds; and (iii) the fiscal policy shocks account for up to 13% of the variance of forecast errors in bond yields.