Federal Government Budget Deficits and Interest Rates: A Brief Note

This empirical note investigates the impact of the federal budget deficit upon the nominal long term rate of interest. The analysis differs from the existing literature on a number of counts. To begin with, the analysis uses the most updated evidence available on the structural deficit, as well as newly available data on inflationary expectations. Next, unlike previous studies, the variable federal purchases of goods and services is expressly introduced into the model as an explanatory variable. In addition, since the total federal deficit is in this paper broken into its two component parts, the structural deficit (which is exogenous) and the cyclical deficit (which is not exogenous), the model expressly deals with the problem of simultaneity bias involving the cyclical deficit. Finally, the monetary policy measure, government purchases of goods and services, and the two deficit measures are not only expressed in real terms but also are divided by trend real GNP; this is because monetary policy actions, government purchases of goods and services, and the budget deficit must all be judged relative to the size of the economy. The 2SLS estimation reveals that federal budget deficits act to elevate the nominal long term interest rate.