The Effects of Budget Deficits on Interest Rates: A Review of Empirical Results

Abstract

Laubach provides a critical review of the empirical literature that focuses on the effects of budget deficits on interest rates. The main empirical problem in estimating this relationship is to control for other factors determining real interest rates. In particular, the simultaneous response of monetary policy and automatic stabilisers can in principle mask the effect of discretionary fiscal policy on interest rates. The paper stresses that simple regressions of current interest rates on current budget deficit yield ambiguous results which are consistent with the view that endogeneity problems in such regressions are pervasive. The paper considers different solutions for coping with these problems. It shows that when endogeneity problems are properly accounted for, mainly by adequately considering expectations of both deficits and interest rates, available studies tend to find strong evidence that increases in budget deficits raise interest rates.