Candidate Number 2864B

Economics Tripos Part IIA Paper 3

Take Home Examination
Question 1: Do large government deficits raise long-term interest rates?
Assess using time-series data on one country.

Contents

1. Introduction
2. Theory
3. Literature review
4. The model
5. Data
6. Estimation
7. Conclusion
8. Appendix

Word Count: 1993 (Excluding footnotes and Appendix)

1|Page

1. Introduction
The relationship between government deficits and long-term interest rates is a topic of
frequent debate. The two graphs below show the development of 10 Year US Treasury
Note Yields and the US federal deficit as share of GDP over the last 55 Years.

At first sight, it looks as if there is a weak inverse relationship between the two series, so
that higher deficits are correlated with higher interest rates. Using time series data on
the United States, I will estimate a vector autoregressive model (VAR) to see whether
large government deficits actually raise long-term interest rates.

2|Page

2. Theory
Economic theory suggests several ways in which government deficits can raise long-term
interest rates.
1. More bonds issued by the government due to higher deficits increases bond
supply, which lowers their price. As bond prices and interest rates are inversely
related, this raises bond interest rates.1
2. Persistent government deficits lead to an increasing stock of debt, which could let
investors doubt the long-run ability of the government to serve the debt. They
may demand a higher risk premium, leading to higher interest rates as a result.2
3. If consumers viewed increased bond holdings as a consequence of government
deficits as wealth, higher consumption would increase output and money demand,
which subsequently raises the interest rate.3
4. In the IS-LM model, a bond-financed fiscal expansion requires an increase in the
interest rate to restore equilibrium in the money market.4 As the government
deficit persists, this will impact on long-term rates.
However, advocates of the Ricardian equivalence hypothesis (REH) endorse a different
view concerning the effect of deficits. According to REH, individuals realize that
government deficits mean future tax increases as the debt must ultimately be paid for,
so they adjust their saving behaviour accordingly. With private saving going up in
response to a decrease in public saving, any crowding out effect is eliminated.5
In addition, causality between deficits and interest rates may run both ways. Reverse
causality could happen through the following channels:6
1. Higher interest rates would mean higher servicing costs for the existing stock of
debt, which increases future deficits.
2. An increase in interest rates reduces investment, which lowers output and the
capital stock, thereby increasing both the cyclical and structural deficit.
3. The collapse in investment and subsequent fall in output following higher interest
rates could induce the government to undertake additional investments to
stimulate the economy, thereby raising the deficit even further.

The Economics of Money, Banking and Financial Markets, Frederic S. Mishkin, Ch5, 8th Edition.

Truman (2001)

Ussher (1998), p2.

Evans (1987), p282.

Barro (1979), p940.

Ussher (1998), p13-14.

3|Page

3. Literature Review
Empirical studies examining the relationship between deficits and interest rates have
provided mixed results. Studies that have found positive effects of deficits on interest
rates include Hoelscher (1986), Miller and Russek (1991, 1996), Cebula and Koch (1994)
and Engen and Hubbard (2004). Others have found no significant relationships, such as
Zimmerman (1997) or Evans (1985). By 2003, Gale and Orszag (2003) count 30 studies
for the US that find a positive relationship and 30 that do not.
A more recent approach has been the inclusion of expected deficits into the analysis.
Studies that incorporate expectations tend to find more significant positive relationships,
such as Elmendorf (1993), who concludes that higher deficits have a positive impact on
five-year bond yields. Laubach (2003) and Laubach, Engen and Hubbard (2004) use CBO
projections to find that increases in projected deficits as well as a higher projected debtto-GDP ratio raise long-term interest rates.
Studies using VARs to determine the relationship between deficits and interest rates
include Plosser (1987), Evans (1987), Miller and Russek (1996) and Dai and Phillippon
(2004). Whereas the former two find no relationship between deficits and interest rates,
the study by Miller and Russek concludes that innovations in the deficit explains between
10-50% of the innovations in the long-term interest rate, if Ricardian equivalence
specifications are excluded. Dai and Phillipon use a structural VAR with a no-arbitrage
restriction for their analysis and conclude that a 1% increase in the deficit/GDP ratio
raises the 10-Year US Bond yield by 41 basis points.

4. The model
As mentioned earlier, causation between deficits and interest rates may run both ways,
which means that we would have to model both variables as endogenous. If we ignored
this bilateral causality and took government deficits as exogenous to do a single
equation regression, we would have simultaneity bias. The independent variable would
be correlated with the error terms, which renders all OLS estimates biased and
inconsistent.7
Because of the possible endogeneity, a vector autoregressive model (VAR) was used. A
VAR does not need an a priori distinction between exogenous and endogenous variables.
By using such atheoretical VARs, which include all variables as endogenous, we do not
have to impose any prior restrictions. Since all regressors are lagged variables, we can

Modern Econometrics, Thomas (1997), Ch8.

4|Page

assume that they are contemporaneously uncorrelated with the error term, so that each
equation can be consistently estimated.8
In deciding which other variables determine the interest rate and should be included in
the VAR, basic economic theory was applied. According to the theory of liquidity
preference, money demand depends positively on income and negatively on the interest
rate. Together with real money supply, this equality determines the interest rate:9

M / P = L(i, Y )

(1)

Therefore, we should include real GDP, money supply and a measure of the price level as
additional variables. A relationship between nominal and real interest rates is given by
the Fisher equation:10

i = r

+ e

( 2)

This suggests that we should include expected inflation as well if we use nominal interest
rates as dependent variable. Inflation expectations were modelled as adaptive, with
expected inflation being equal to last periods inflation. As a VAR includes lags, using
actual inflation will then account for both changes in the price level (as suggested by
equation (1)) and expected inflation. In order to see whether large deficits have a
separate effect on interest rates, a dummy variable for large deficits is included. The
dummy is equal to one if the deficit is higher than its mean value.
Accounting for non-stationarity of some series and seasonal effects, the VAR model then
looks as follows:11

it

def t
2
rdgp = +
t

3
t

4
m2 grow

t

1i

2i
n

3i
i =1
4i

5i

1i
2i
3i
4i
5i

1i
2i
3i
4i
5i

1i
2i
3i
4i
5i

it i
1i

2i def t i 2
3i rdgpt i + 3

4i
t i

5i m2 growt i 5

12
22
32
42
52

13
23
33
43
53

14
1t

lart
24 2t
q2
34 t + 3t

q3
44 t 4t
q4
54 t 5t

If higher government deficits raise interest rates, we expect the coefficients (1i) to be
positive. If larger deficits have a separate impact on interest rates, we would expect (1)
to be significant.

Modern Econometrics, Thomas (1997), p459.

Macroeconomics, Mankiw (2006), Ch4.

10

Macroeconomics, Mankiw (2006), Ch4.

11

i is the change in nominal interest rates, def is the change in deficit (with a positive number denoting a

deficit and a negative number denoting a surplus), rgdp is the growth in real GDP,

is the inflation rate,

m2growth is the change in the growth of M2, lar is a dummy for large deficits and q2/3/4 are dummy
variables for the second, third and forth quarter, respectively.

5|Page

5. Data12
The dataset was taken for the United States from the Federal Reserve Economic Data
(FRED). In this context, the 10-Year Treasury Note Rate is used for long-term interest
rates. The time period examined goes from 1966Q2 to 2009Q4.
The US was chosen for the analysis because it has the most comprehensive dataset with
a large sample size. This is especially important in using VARs because of two reasons:
Firstly, the occurrence of lagged dependent variables in VARs renders the OLS estimates
biased, but they are still consistent.13 Secondly, VARs tend to consume numerous
degrees of freedom because of the large number of regressors due to many lags.
Therefore, it is desirable to have a large sample size in order to obtain precise estimates.

6. Estimation
First, the augmented Dickey-Fuller test was carried out to test for the stationarity of the
series. Non-stationary series (interest rates, deficits, money supply growth) were
differenced, giving rise to a percentage point interpretation of the differenced series. As
the data for the federal deficit is not seasonally adjusted, seasonal dummies were
included to remove seasonal effects.
In deciding the number of lags to include in the VAR, the Akaike information criterion
suggested a lag length of 3 quarters. However, the LM test for serial correlation indicates
autocorrelation at this lag length. Therefore, successive lags are added until the VAR
model passes all diagnostic tests at the 5% level, giving us 7 lags.14
The numerical result for this VAR estimation can be found in the Appendix.15 For the
regression with i (changes in the 10-Year Bond rate) as dependent variable, the large
deficits dummy coefficient is insignificant. The coefficients on def (changes in the
federal deficit) have mixed signs, with the first three lags having negative coefficients
between -0.10 and 0 and the four coefficients after that being positive with values
between 0.06 and 0.08. They are all individually statistically insignificant at the 5% level.

12

See Appendix A3.1 for data source documentation and A3.2 for a full table.

13

Modern Econometrics, Thomas (1997), p209.

14

Diagnostic tests for A1.1.1 VAR_01_66to09: LM autocorrelation test (see Appendix A1.1.2), White
heteroskedasticity test (the joint test gave a p-value of 0.163), Jarque Bera normality test (no normality, but
the large sample size allows the application of the central limit theorem, so the residuals are asymptotically
normally distributed), Ramsey RESET Test (using a squared term for the equation with i as dependent
variable, we obtained a p-value of 0.1993).
15

See Appendix A1.1.1 VAR_01_66to09 for VAR estimation output. See A1.1.2 for residuals plot and
A1.1.3 for impulse functions.

6|Page

However, the coefficients could still be jointly significant. We will test whether all seven
lags of def are relevant in explaining i by using an F-Test for joint exclusion
restrictions. This is testing for Granger causality.
Our null hypothesis is that all the (1i) coefficient are jointly zero, which would mean
that def does not Granger cause i. The test shows us that this null hypothesis cannot
be rejected at a 5% significance level.16 Moreover, the Granger test could not detect any
reverse causality running from interest rates to deficits either. We conclude from this
VAR that there is no evidence that higher government deficits raise long-term interest
rates. The only variable that Granger causes (at a 5% level) changes in the interest
rates in this VAR is inflation, which has a positive effect.
By undertaking sensitivity analysis, we will now see whether the negative results are
robust to changing samples and adding variables.
In re-estimating the VAR for the subperiod 1991Q1-2009Q4, we can see whether the
results hold in a low-inflation environment, in which movements in the nominal interest
rate are less influenced by high and volatile inflation.17 The Granger causality test again
finds no Granger causality in any direction, with the large deficit dummy still being
insignificant. 18 Moreover, inflation does not Granger cause changes in the interest rate
any more, suggesting that its significant effect was confined to the high inflation period
in the 70s and 80s.
Now we include a new variable to our VAR, the current account as share of GDP. Possible
effects of deficits on interest rates could be diminished by the fact that financial markets
have become increasingly integrated. High deficits then do not necessarily increase
interest rates via the crowding out effect, as the government can borrow funds from
abroad. To account for the effect of capital flows, the current account as share of GDP
(differenced for stationarity) was included as another endogenous variable.
The modified VAR was estimated for the time period 1966Q2-2009Q4 using 7 lags and
passes all the diagnostic tests.19 It yields the same qualitative results as our first VAR.20
The (1i) coefficients are all individually insignificant and range between -0.17 and 0.12.

16

See Appendix A1.1.4 VAR_01_66to09 Granger causality test

17

Diagnostic tests for A1.2.1 VAR_02_91to09: LM autocorrelation test (p-values for 8 lags ranged from
0.2801 to 0.9687, with a p-value of 0.03 for the 8th lag) White heteroskedasticity test (the p-value of joint test
is 0.4125), Jarque Bera normality test (no normality, but the large sample size allows the use of central limit
theorem, so residuals are asymptotically normally distributed), Ramsey RESET Test (using a squared term for
the equation with i as dependent variable, we obtained a p-value of 0.8655).

18

See Appendix A1.2.1 VAR_02_91to09 for estimation output and A1.2.2 VAR_02_91to09 Granger
causality test

19

Diagnostic tests: LM autocorrelation test (the p-values for 8 lags ranged from 0.0563 to 0.4989), White
heteroskedasticity test (the p-value of the joint test is 0.2279), Jarque Bera normality test (no normality, but
large sample size allows use of central limit theorem), Ramsey RESET Test (using a squared term for the
equation with i as dependent variable, we obtained a p-value of 0.2528).
20

See Appendix A1.3.1 VAR_03_CurrentAccount for VAR estimation output

7|Page

A test for Granger causality shows that there is no evidence for past changes in deficits
Granger causing changes in the interest rates at a 5% significance level.21 The coefficient
on the large deficit dummy is insignificant. Again, inflation is the only variable that
Granger-causes changes in the interest rate.
Sensitivity analysis has supported the robustness of our results. We conclude that there
is no evidence for government deficits of any size raising long-term interest rates.

7. Conclusion
Using a vector autoregressive model, we found no evidence for the claim that large
government deficits raise long-term interest rates. This does not necessarily prove
Ricardian equivalence right, since the actual mechanism through which interest rates are
equilibrated may be quite different from what REH postulates. One possible explanation
for our negative results is that worldwide capital flows were insufficiently modelled. One
way to deal with this is to estimate the model for the world as a closed economy, where
a first attempt has been made by Ford and Laxton (1999). Possible effects could also be
mitigated for the US in particular, because US bonds are considered as a very safe asset.
Investors might be less worried about US budget deficits than they would be in other
countries, which reduces the risk premium effect. Part of the results can also be
attributed to shortcomings of the VAR model, as VARs are more likely to suffer from
measurement error, which biases the coefficients towards zero.22 In the future, more
efforts can be undertaken in the direction of looking at expected deficits rather than past
deficits, where studies have already delivered promising results. Taken together, all
these suggestions and limitations point to much scope for future studies in this area of
research.

21

See Appendix A1.3.2 VAR_03_CurrentAccount Granger causality test

22

Gale and Orszag (2004), p27.

8|Page

8. Appendix

Overview
A1.1.1

Table: Vector autoregression estimation output VAR_01_66to09

A1.1.2

Graph/Table: VAR_01_66to09 residuals plot and serial correlation LM Test

A1.1.3

Graph: VAR_01_66to09 Impulse response functions

A1.1.4

Table: VAR_01_66to09 Granger causality test results

A1.2.1

Table: Vector autoregression estimation output VAR_02_91to09

A1.2.2

Table: VAR_02_91to09 Granger causality test results

A1.3.1

Table: Vector autoregression estimation output VAR_03_CurrentAccount

A1.3.2

Table: VAR_03_CurrentAccount Granger causality test results

A2

References

A3.1

Data source documentation

A3.2

Table: Full Data table

9|Page

A1.1.1

Table: Vector autoregression estimation output VAR_01_66to09

VAR_01_66to09

Included observations: 167 after adjustments

Sample (adjusted): 1968Q2 2009Q4

Standard errors in ( ) & t-statistics in [ ]

DINTEREST

DDEFICIT

GDPGROWTH

INFLATION

DM2GROWTH

-0.265141
-0.18616
[-1.42430]

-0.171103
-0.17026
[-1.00498]

0.594538
-0.30275
[ 1.96377]

-0.173569
-0.23682
[-0.73293]

0.481903
-0.29615
[ 1.62723]

DDEFICIT(-1)

-0.001414
-0.08925
[-0.01584]

-0.709845
-0.08163
[-8.69581]

-0.258683
-0.14516
[-1.78207]

-0.167765
-0.11354
[-1.47753]

-0.213776
-0.14199
[-1.50555]

DDEFICIT(-2)

-0.062026
-0.11399
[-0.54415]

-0.533681
-0.10425
[-5.11918]

-0.18734
-0.18538
[-1.01055]

0.117582
-0.14501
[ 0.81086]

-0.307614
-0.18134
[-1.69635]

DDEFICIT(-3)

-0.102381
-0.12142
[-0.84319]

-0.426973
-0.11105
[-3.84486]

-0.105671
-0.19747
[-0.53512]

0.19768
-0.15447
[ 1.27977]

-0.265578
-0.19317
[-1.37487]

DDEFICIT(-4)

0.07437
-0.12801
[ 0.58096]

-0.084439
-0.11708
[-0.72121]

-0.191795
-0.20819
[-0.92124]

0.22464
-0.16285
[ 1.37942]

-0.381472
-0.20365
[-1.87317]

DDEFICIT(-5)

0.077708
-0.12204
[ 0.63673]

-0.209783
-0.11162
[-1.87946]

0.079429
-0.19848
[ 0.40018]

0.318017
-0.15526
[ 2.04833]

-0.478322
-0.19415
[-2.46362]

DDEFICIT(-6)

0.063933
-0.12128
[ 0.52714]

-0.116505
-0.11092
[-1.05031]

-0.269467
-0.19725
[-1.36613]

0.12596
-0.15429
[ 0.81639]

-0.380494
-0.19294
[-1.97204]

DDEFICIT(-7)

0.072754
-0.0953
[ 0.76345]

0.000871
-0.08716
[ 0.00999]

-0.173464
-0.15499
[-1.11923]

0.021897
-0.12123
[ 0.18062]

-0.107968
-0.1516
[-0.71217]

DUMMY_LARGE

-0.101984
-0.09378
[-1.08753]

0.558235
-0.08577
[ 6.50879]

-0.116876
-0.15251
[-0.76633]

-0.19461
-0.1193
[-1.63131]

0.08613
-0.14919
[ 0.57734]

other variables

R-squared
Adj. R-squared
Sum sq. resids

0.376305
0.184776
28.90378

0.734448
0.652901
24.17714

0.372323
0.179571
76.45097

0.61561
0.497569
46.77675

0.426628
0.250553
73.15163

10 | P a g e

A1.1.2

Graph/Table: VAR_01_66to09 residuals plot and serial correlation

LM Test

DINTEREST Residuals

DDEFICIT Residuals

1.5

1.0
2
0.5
1

0.0
-0.5

-1.0
-1
-1.5
-2.0

-2
70

75

80

85

90

95

00

05

70

75

GDPGROWTH Residuals

80

85

90

95

00

05

INFLATION Residuals

-1

-1

-2

-2

-3
70

75

80

85

90

95

00

05

70

75

80

85

90

95

00

05

DM2GROWTH Residuals
2

-1

-2
70

75

80

85

90

95

00

05

11 | P a g e

A1.1.3

Graph: VAR_01_66to09 Impulse response functions

Response of DINTEREST to Cholesky

One S.D. DDEFICIT Innovation
.15

.10

.05

.00

-.05

-.10

-.15
1

10

10

Response of DDEFICIT to Cholesky

One S.D. DINTEREST Innovation
.20
.15
.10
.05
.00
-.05
-.10
-.15
-.20
1

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A1.1.4

Table: VAR_01_66to09 Granger causality test results

VAR Granger Causality/Block Exogeneity Wald Tests

Date: 05/05/10 Time: 19:27
Sample: 1947Q1 2009Q4
Included observations: 167

Dependent variable: DINTEREST

Excluded

Chi-sq

df

Prob.

DDEFICIT
GDPGROWTH
INFLATION
DM2GROWTH

3.643830
8.104320
17.09830
11.91664

7
7
7
7

0.8198
0.3235
0.0168
0.1033

All

39.99320

28

0.0662

Dependent variable: DDEFICIT

Excluded

Chi-sq

df

Prob.

DINTEREST
GDPGROWTH
INFLATION
DM2GROWTH

10.77719
12.62192
6.525555
7.561830

7
7
7
7

0.1486
0.0819
0.4799
0.3728

All

46.79342

28

0.0144

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A1.2.1

Table: Vector autoregression estimation output VAR_02_91to09

VAR_02_91to09

Included observations: 76

Sample: 1991Q1 2009Q4

Standard errors in ( ) & t-statistics in [ ]

DINTEREST

DDEFICIT

GDPGROWTH

INFLATION

DM2GROWTH

-0.390838
-0.44715
[-0.87406]

-0.702851
-0.72929
[-0.96375]

1.446004
-0.83798
[ 1.72559]

1.903676
-0.7474
[ 2.54706]

-0.283247
-0.73623
[-0.38473]

DDEFICIT(-1)

-0.090547
-0.1227
[-0.73794]

-0.625071
-0.20013
[-3.12340]

-0.23924
-0.22995
[-1.04040]

-0.286478
-0.2051
[-1.39680]

0.059454
-0.20203
[ 0.29428]

DDEFICIT(-2)

0.085836
-0.17767
[ 0.48313]

-0.441449
-0.28977
[-1.52346]

-0.333808
-0.33295
[-1.00257]

-0.324128
-0.29696
[-1.09147]

-0.049441
-0.29253
[-0.16901]

DDEFICIT(-3)

0.07606
-0.19443
[ 0.39119]

-0.214111
-0.31712
[-0.67518]

-0.389666
-0.36438
[-1.06940]

-0.429618
-0.32499
[-1.32193]

0.013112
-0.32014
[ 0.04096]

DDEFICIT(-4)

0.138224
-0.19939
[ 0.69325]

0.118391
-0.32519
[ 0.36406]

-0.293815
-0.37366
[-0.78632]

-0.557069
-0.33327
[-1.67152]

-0.147529
-0.32829
[-0.44939]

DDEFICIT(-5)

0.257936
-0.17988
[ 1.43397]

-1.38E-02
-0.29337
[-0.04695]

-0.230108
-0.3371
[-0.68262]

-0.268976
-0.30066
[-0.89462]

-0.427319
-0.29617
[-1.44284]

DDEFICIT(-6)

0.141545
-0.16356
[ 0.86540]

0.097133
-0.26676
[ 0.36412]

-0.405803
-0.30652
[-1.32391]

-0.233567
-0.27339
[-0.85434]

-0.626154
-0.2693
[-2.32510]

DDEFICIT(-7)

0.03267
-0.12343
[ 0.26469]

0.101211
-0.2013
[ 0.50277]

-0.213772
-0.23131
[-0.92420]

-0.063592
-0.2063
[-0.30824]

-0.387133
-0.20322
[-1.90498]

DUMMY_LARGE

-0.084003
-0.13448
[-0.62464]

0.76526
-0.21934
[ 3.48900]

-0.042911
-0.25202
[-0.17027]

-0.183602
-0.22478
[-0.81680]

0.212917
-0.22142
[ 0.96159]

other variables

R-squared
Adj. R-squared
Sum sq. resids

0.675231
0.323399
3.63314

0.832256
0.650534
9.664411

0.559291
0.081856
12.75973

0.556533
0.076111
10.15041

0.817453
0.619693
9.849296

14 | P a g e

A1.2.2

Graph: VAR_02_91to09 Granger causality test result

VAR Granger Causality/Block Exogeneity Wald Tests

Date: 05/05/10 Time: 19:27
Sample: 1991Q1 2009Q4
Included observations: 76

Dependent variable: DINTEREST

Excluded

Chi-sq

df

Prob.

DDEFICIT
GDPGROWTH
INFLATION
DM2GROWTH

5.470566
5.073614
5.970864
6.628270

7
7
7
7

0.6027
0.6510
0.5432
0.4686

All

27.59968

28

0.4858

Dependent variable: DDEFICIT

Excluded

Chi-sq

df

Prob.

DINTEREST
GDPGROWTH
INFLATION
DM2GROWTH

5.132001
13.38259
6.277891
4.130835

7
7
7
7

0.6439
0.0633
0.5077
0.7646

All

40.59307

28

0.0585

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A1.3.1

Table: Vector autoregression estimation output

VAR_03_CurrentAccount

VAR_03_CurrentAccount
Sample (adjusted): 1968Q2 2009Q4

Included observations: 167 after adjustments

Standard errors in ( ) & t-statistics in [ ]

DINTEREST

DDEFICIT

GDPGROWTH

INFLATION

DM2GROWTH

DCURACNT

-0.271418
-0.18432
[-1.47255]

-0.165014
-0.16976
[-0.97202]

0.615461
-0.30074
[ 2.04647]

-0.219424
-0.2292
[-0.95733]

0.496245
-0.29803
[ 1.66510]

-0.010857
-0.0316
[-0.34352]

DDEFICIT(-1)

0.002194
-0.08999
[ 0.02438]

-0.706698
-0.08289
[-8.52612]

-0.238593
-0.14684
[-1.62489]

-0.179661
-0.11191
[-1.60545]

-0.181892
-0.14551
[-1.25002]

0.031248
-0.01543
[ 2.02505]

DDEFICIT(-2)

-0.095524
-0.11599
[-0.82356]

-0.503992
-0.10683
[-4.71772]

-0.163557
-0.18925
[-0.86423]

0.037488
-0.14423
[ 0.25991]

-0.252777
-0.18754
[-1.34783]

0.026233
-0.01989
[ 1.31900]

DDEFICIT(-3)

-0.172273
-0.12395
[-1.38988]

-0.364954
-0.11416
[-3.19686]

-0.074756
-0.20224
[-0.36964]

0.054408
-0.15413
[ 0.35300]

-0.179121
-0.20041
[-0.89376]

0.051732
-0.02125
[ 2.43413]

DDEFICIT(-4)

0.019203
-0.1317
[ 0.14581]

-0.042325
-0.1213
[-0.34893]

-0.166438
-0.21489
[-0.77454]

0.069896
-0.16377
[ 0.42679]

-0.308005
-0.21295
[-1.44639]

0.0111
-0.02258
[ 0.49153]

DDEFICIT(-5)

0.019335
-0.12514
[ 0.15451]

-0.13822
-0.11525
[-1.19926]

0.131495
-0.20418
[ 0.64402]

0.152479
-0.15561
[ 0.97988]

-0.361103
-0.20234
[-1.78468]

4.95E-05
-0.02146
[ 0.00231]

DDEFICIT(-6)

0.028568
-0.12232
[ 0.23356]

-0.085275
-0.11266
[-0.75694]

-0.217834
-0.19958
[-1.09148]

0.032243
-0.1521
[ 0.21198]

-0.324293
-0.19778
[-1.63971]

-0.015448
-0.02097
[-0.73657]

DDEFICIT(-7)

0.117141
-0.09937
[ 1.17881]

0.049448
-0.09153
[ 0.54027]

-0.175084
-0.16214
[-1.07983]

-0.025364
-0.12357
[-0.20526]

-0.04151
-0.16068
[-0.25834]

-0.021007
-0.01704
[-1.23288]

DUMMY_LARGE

-0.150708
-0.09508
[-1.58507]

0.59505
-0.08757
[ 6.79501]

-0.073437
-0.15514
[-0.47337]

-0.282073
-0.11823
[-2.38573]

0.166227
-0.15374
[ 1.08125]

0.026412
-0.0163
[ 1.62008]

0.418756
0.195946
70.79543

0.662089
0.532557
41.12065

0.455067
0.246176
69.52333

0.444215
0.231164
0.781835

R-squared
Adj. R-squared
Sum sq. resids

other variables

0.426186
0.206224
26.59215

0.752229
0.65725
22.55831

16 | P a g e

A1.3.2

Table: VAR_03_CurrentAccount Granger causality test results

VAR Granger Causality/Block Exogeneity Wald Tests

Date: 05/05/10 Time: 19:45
Sample: 1947Q1 2009Q4
Included observations: 167

Dependent variable: DINTEREST

Excluded

Chi-sq

df

Prob.

DDEFICIT
GDPGROWTH
INFLATION
DM2GROWTH
DCURACNT

5.620068
8.625229
17.40420
10.31800
10.43150

7
7
7
7
7

0.5847
0.2807
0.0150
0.1713
0.1654

All

51.50530

35

0.0356

Dependent variable: DDEFICIT

Excluded

Chi-sq

df

Prob.

DINTEREST
GDPGROWTH
INFLATION
DM2GROWTH
DCURACNT

9.930980
13.99562
7.460963
6.758907
8.611454

7
7
7
7
7

0.1925
0.0513
0.3825
0.4544
0.2818

All

55.99862

35

0.0136

17 | P a g e

A2

References

Do Budget Deficits Raise Nominal Interest Rates? Evidence from six countries, Paul Evans (1987),
Journal of Monetary Economics 20 (1987).
Do Budget Deficits Raise Interest Rates? L. Ussher (1998), p4, Working Papers Department of
Economics, Queens College of the City University of New York.
Budget Deficits, National Saving and Interest Rates, W. G. Gale and P. R. Orszag (2004), Brookings
Institution and Tax Policy Center.
World public debt and real interest rates, R. Ford and D. Laxton (1999), International Monetary Fund.
Federal government debt and interest rates, Eric M. Engen and R. Glenn Hubbard (2004), NBER
Macroeconomics Annual, Vol.19 (2004).
A note on interest rates and structural federal budget deficits. John Kitchen (2002), MPRA Paper No.
21069.
Budget Deficits and Interest Rates. A fresh perspective, Ari Aisen and David Hauner (2008), IMF
Working Paper.
Government debt, Douglas W. Elmendorf and N. Gregory Mankiw (1998), Handbook of
Macroeconomics.
New evidence on Deficits and Interest Rates., Gregory Hoelscher (1986), Journal of Money, Credit and
Banking, Vol.18, No.1 (Feb 1987).
New evidence on the Interest Rate effects of Budget Deficits and Debt. Thomas Laubach (2003).
Fiscal policy and the term structure, Charles Plosser (1982), Elsevier Science Publishers.
A note on budget deficits and Interest Rates. Evidence from a small open economy, George
Vamvoukas (1997), Southern Economic Journal, Vol.63, No.3.
A no arbitrage vector autoregression of term structure dynamics with macroeconomic and latent
variables. Andrew Ang and Monica Piazzesi (2003), Journal of Monetary Economics 50 (2003).
Government deficits and interest rates. A no-arbitrage structural VAR approach. Qiang Dai and Thomas
Phillipon (2004), New York University.
Do Federal deficits affect interest rates? Evidence from 3 econometric methods., Stephen M. Miller and
Frank S. Russek (1996), Journal of Macroeconomics, Vol.18.
A Macro finance model of the term structure, monetary policy and the economy., Glenn D. Rudebusch,
Tao Wu (2003).
The effects of Budget deficits on interest rates: A review of empirical results. Thomas Laubach.

18 | P a g e

A2.1

Data source documentation

All data is taken from the Federal Reserve Economic Data (FRED), managed by the
Federal Reserve branch in St. Louis: http://research.stlouisfed.org/fred2/

10 Year Treasury Note monthly rates (GS10)

http://research.stlouisfed.org/fred2/series/GS10?cid=115
For long-term interest rates, the monthly 10-Year Treasury Note rate was used,
averaged over three months to obtain quarterly data.

Federal government debt: Total public debt (GFDEBTN), not adjusted

http://research.stlouisfed.org/fred2/series/GFDEBTN?cid=5
For the deficit, data on total federal debt in million dollars was used: Each value was
subtracted from the quarter before to get the deficit, then division by nominal GDP was
carried out to obtain the deficit in a quarter as percentage of GDP. In this connection, a
positive number is interpreted as a deficit and a negative number as a surplus.

Nominal GDP (GDP)

Used to calculate the deficit and current account balance, seasonally adjusted:
http://research.stlouisfed.org/fred2/series/GDP?cid=106

Real GDP growth (GDPC1), seasonally adjusted

http://research.stlouisfed.org/fred2/series/GDPC1?cid=106
Quarterly data for real GDP was used to get a measure of quarterly growth.

19 | P a g e

Consumer price index for all urban consumers, all items (CPIAUCSL),
seasonally adjusted
http://research.stlouisfed.org/fred2/series/CPIAUCSL?cid=9
Inflation data was calculated using the CPI, dividing each value by the value three
months ago in order to get inflation per quarter.

M2 Money stock (M2SL), seasonally adjusted

http://research.stlouisfed.org/fred2/series/M2SL?cid=29
Money supply growth was obtained by using monthly data on the stock of M2, dividing
each observation by the observation three months ago, which resulted in quarterly M2
growth.

Balance of current account (BOPBCA), seasonally adjusted

http://research.stlouisfed.org/fred2/series/BOPBCA?cid=125
In dividing the balance on current account by nominal GDP, the current account balance
as a share of GDP was obtained.

A3.2

Full Data table

20 | P a g e

Year

Quarter

1966

1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

10 Year
Treasury
4.770
4.780
5.140
5.003
4.583
4.820
5.247
5.643
5.610
5.743
5.460
5.770
6.177
6.353
6.857
7.297
7.367
7.713
7.460
6.853
6.017
6.247
6.483
5.890
6.033
6.143
6.290
6.373
6.603
6.807
7.207
6.753
7.053
7.543
7.963
7.670
7.540
8.050
8.297
8.063
7.753
7.773
7.730
7.190
7.353
7.370
7.357
7.597
8.010
8.320
8.490
8.820
9.107
9.113
9.103
10.447
11.987
10.477
10.953
12.423
12.960
13.750
14.847
14.087
14.293
13.930
13.117
10.667
10.563
10.543
11.627
11.687
11.943
13.200
12.867
11.743
11.583
10.813
10.337
9.760
8.557
7.603
7.307
7.263
7.193
8.343
8.877
9.123

Deficit %
of GDP

-0.618
1.072
0.559
0.198
-0.962
1.525
0.996
0.532
-0.446
1.001
0.342
0.155
-0.668
0.776
0.741
0.366
-0.182
0.815
0.954
0.224
0.495
1.300
0.997
0.262
-0.073
0.584
1.088
0.739
-0.093
0.230
0.585
0.310
0.037
0.466
0.714
1.059
1.415
1.194
1.298
1.321
1.085
0.757
0.972
0.781
0.253
1.157
0.935
0.836
0.474
0.932
0.717
0.300
0.312
0.812
0.683
0.672
0.509
1.032
0.738
1.113
0.209
0.835
0.969
1.005
0.560
1.884
1.628
1.362
2.093
1.563
0.880
1.358
1.231
1.477
2.203
1.144
1.501
1.122
2.803
0.924
1.615
1.452
1.942
0.680
1.313
0.839
1.646

Real GDP
growth
0.333
0.658
0.810
0.881
0.021
0.798
0.763
2.061
1.698
0.684
0.433
1.575
0.291
0.632
-0.470
-0.157
0.181
0.890
-1.060
2.758
0.567
0.798
0.278
1.788
2.372
0.958
1.647
2.558
1.157
-0.534
0.954
-0.877
0.256
-0.989
-0.394
-1.216
0.764
1.684
1.306
2.273
0.752
0.490
0.726
1.161
1.987
1.788
-0.021
0.341
3.934
0.980
1.323
0.167
0.094
0.719
0.275
0.322
-2.049
-0.186
1.850
2.078
-0.798
1.215
-1.246
-1.641
0.542
-0.386
0.079
1.244
2.248
1.972
2.067
1.940
1.727
0.972
0.814
0.944
0.847
1.562
0.759
0.961
0.402
0.964
0.483
0.554
1.063
0.867
1.711
0.517

Inflation
1.255
0.527
1.233
0.152
0.608
0.906
0.898
1.187
0.880
1.453
1.146
1.133
1.681
1.377
1.359
1.609
1.583
1.039
1.285
1.269
0.501
1.247
0.739
0.733
0.728
0.723
0.957
1.185
2.342
1.144
3.167
2.632
2.778
2.495
3.448
2.549
1.338
1.887
1.667
1.639
0.538
1.604
1.579
1.382
2.215
1.333
1.316
1.786
1.914
2.504
2.443
2.086
3.066
3.399
3.014
3.723
3.718
2.101
2.542
2.952
2.179
2.694
2.077
1.071
0.636
2.632
0.615
-0.204
0.919
1.012
1.002
1.290
1.175
0.774
0.961
0.571
1.230
0.654
0.743
1.290
-1.092
0.736
0.639
1.089
1.167
0.976
1.054
0.870

M2
Growth

0.341
1.019
1.240
2.180
2.886
2.350
1.775
1.574
1.848
2.199
2.098
1.124
0.660
0.673
1.063
-0.204
1.818
2.888
2.693
4.013
3.220
2.766
2.763
2.884
2.858
3.608
2.974
1.160
2.050
0.729
2.029
1.535
0.974
1.350
1.455
3.178
4.278
2.328
2.886
3.331
2.404
3.563
3.573
2.952
2.259
2.225
2.049
1.618
1.823
2.130
1.427
2.224
2.332
1.784
1.527
1.315
2.882
2.543
1.394
3.255
1.368
2.372
2.823
1.892
1.652
2.181
4.734
3.501
1.772
1.664
1.851
2.500
1.454
1.586
3.264
1.837
2.279
1.587
1.384
2.216
2.715
2.331
2.088
0.874
0.411
1.297
1.178

CA as %
of GDP
0.127
0.101
0.061
0.096
0.107
0.081
0.067
0.056
0.022
0.036
0.015
-0.005
0.013
-0.013
0.005
0.036
0.061
0.094
0.049
0.021
0.062
-0.037
-0.047
-0.102
-0.142
-0.138
-0.103
-0.088
0.011
0.064
0.197
0.236
0.111
0.007
-0.019
0.034
0.268
0.312
0.245
0.281
0.145
0.091
-0.005
0.009
-0.139
-0.151
-0.133
-0.278
-0.327
-0.166
-0.157
-0.028
-0.017
-0.027
0.036
-0.004
-0.127
-0.034
0.156
0.082
0.032
0.040
0.066
0.024
-0.009
0.117
-0.123
-0.151
-0.074
-0.225
-0.360
-0.419
-0.550
-0.600
-0.588
-0.659
-0.571
-0.687
-0.735
-0.802
-0.781
-0.807
-0.847
-0.863
-0.852
-0.853
-0.842
-0.845

Year

Quarter

1988

1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

10 Year
Treasury
8.417
8.910
9.100
8.957
9.207
8.773
8.107
7.907
8.423
8.677
8.703
8.397
8.017
8.130
7.940
7.347
7.303
7.377
6.617
6.743
6.280
5.990
5.617
5.607
6.067
7.083
7.333
7.837
7.483
6.620
6.323
5.893
5.910
6.720
6.780
6.343
6.563
6.697
6.243
5.907
5.587
5.597
5.203
4.670
4.983
5.540
5.883
6.140
6.480
6.177
5.893
5.567
5.050
5.270
4.980
4.770
5.077
5.100
4.260
4.007
3.920
3.620
4.233
4.287
4.020
4.600
4.303
4.173
4.297
4.160
4.213
4.490
4.570
5.070
4.897
4.630
4.680
4.847
4.730
4.260
3.663
3.887
3.863
3.253
2.737
3.313
3.517
3.460

Deficit %
of GDP
1.104
1.169
1.038
1.534
1.036
1.067
1.030
1.674
1.707
1.569
1.532
2.236
1.683
1.207
2.090
2.203
1.264
1.618
1.231
1.717
0.809
1.815
0.874
1.796
0.570
0.981
0.648
1.470
0.870
1.171
0.300
0.192
1.655
0.548
0.794
1.209
0.697
-0.056
0.435
1.038
0.460
0.062
-0.241
0.962
0.404
-0.136
0.182
1.234
-0.027
-0.873
-0.116
-0.118
1.083
-0.455
0.777
1.295
0.590
1.125
0.945
1.630
0.500
1.860
0.992
1.851
1.130
1.199
0.862
1.754
1.444
0.467
0.745
1.803
1.504
0.363
0.639
1.256
1.211
0.127
0.976
1.541
1.438
0.374
3.713
4.761
3.018
2.937
2.522
2.750

Real GDP
growth
1.284
0.516
1.335
0.939
0.748
0.793
0.218
1.045
0.397
-0.002
-0.876
-0.484
0.675
0.421
0.392
1.098
1.063
1.032
1.052
0.184
0.640
0.526
1.321
0.974
1.368
0.644
1.111
0.245
0.215
0.840
0.697
0.685
1.729
0.870
1.092
0.769
1.483
1.255
0.767
0.945
0.899
1.319
1.731
0.891
0.782
1.272
1.796
0.261
1.951
0.084
0.592
-0.330
0.656
-0.274
0.353
0.859
0.531
0.500
0.021
0.405
0.798
1.676
0.899
0.704
0.711
0.735
0.868
0.998
0.426
0.760
0.517
1.312
0.360
0.027
0.731
0.300
0.794
0.887
0.527
-0.182
0.362
-0.676
-1.371
-1.647
-0.185
0.555
1.360
0.800

Inflation
1.034
1.109
1.181
1.084
1.568
1.137
0.723
1.675
1.098
1.241
2.222
0.975
0.297
0.814
0.734
0.802
0.795
0.789
0.854
0.776
0.700
0.487
0.761
0.481
0.615
0.815
0.674
0.736
0.864
0.527
0.590
0.782
0.905
0.577
0.764
0.759
0.314
0.313
0.686
0.310
0.123
0.617
0.429
0.488
0.729
0.482
0.840
0.714
0.945
1.053
0.695
0.978
0.456
0.567
0.113
0.056
0.900
0.390
0.667
0.773
0.329
0.273
0.653
0.757
0.590
0.907
0.899
0.419
1.096
0.620
2.155
0.050
0.703
1.147
-0.542
0.779
1.272
0.822
0.685
1.508
0.886
2.333
-1.036
-2.247
0.401
0.923
0.737
0.569

M2
Growth
2.223
1.279
0.623
0.885
0.477
1.547
2.037
1.666
1.100
0.683
1.078
0.879
1.373
0.689
0.119
0.618
0.546
-0.179
0.886
-0.128
-0.222
0.899
0.432
0.540
0.282
0.183
-0.123
0.212
0.183
1.959
1.278
0.958
1.387
1.055
0.852
1.379
1.141
1.221
1.655
1.676
1.974
1.554
2.505
2.169
1.443
1.510
1.231
1.666
2.078
0.461
1.757
2.208
3.177
1.483
2.575
2.292
0.744
1.730
2.010
1.697
1.686
2.476
0.202
0.132
1.968
1.403
1.347
0.765
0.601
1.206
1.509
1.385
1.021
1.299
1.731
1.725
1.466
1.273
1.811
1.321
2.323
1.138
2.695
3.667
0.504
1.141
0.595
-0.027

CA as %
of GDP
-0.666
-0.571
-0.543
-0.598
-0.532
-0.461
-0.399
-0.426
-0.414
-0.337
-0.368
-0.244
0.169
0.042
-0.069
-0.089
-0.101
-0.189
-0.230
-0.289
-0.226
-0.312
-0.318
-0.412
-0.361
-0.406
-0.443
-0.503
-0.430
-0.435
-0.362
-0.307
-0.359
-0.383
-0.457
-0.392
-0.443
-0.348
-0.389
-0.507
-0.512
-0.590
-0.666
-0.674
-0.692
-0.779
-0.858
-0.890
-1.018
-1.001
-1.080
-1.094
-1.058
-0.948
-1.017
-0.851
-0.992
-1.090
-1.085
-1.145
-1.241
-1.184
-1.156
-1.103
-1.178
-1.325
-1.331
-1.477
-1.409
-1.431
-1.455
-1.625
-1.507
-1.514
-1.597
-1.381
-1.443
-1.361
-1.210
-1.153
-1.247
-1.295
-1.266
-1.079
-0.735
-0.691
-0.719
-0.800

21 | P a g e