Why deficit news affects interest rates

Abstract

This article provides evidence on the relationship between budget deficits and interest rates. Wachtel and Young have demonstrated that announcements of larger deficits have raised interest rates. They offered three explanations for this: Agents expected larger deficits to crowd out private spending and raise real rates; they expected, according to the neo-Ricardian model, that government spending increases would raise interest rates; or they expected larger deficits to be monetized and cause inflation. Here evidence from exchange rates and government spending changes is used to demonstrate that financial markets expected deficits do crowd out investment and net exports, raising real interest rates and the dollar.