Why does fiscal policy increase interest rates

But if consumers decide to spend some of the extra disposable income they receive from a tax cut because they are myopic about future tax payments, for example , then Ricardian equivalence will not hold; a tax cut will lower national saving and raise aggregate demand. In addition to its effect on aggregate demand and saving, fiscal policy also affects the economy by changing incentives.

Taxing an activity tends to discourage that activity. By reducing the level of taxation, or even by keeping the level the same but reducing marginal tax rates and reducing allowed deductions, the government can increase output.

Incentive effects of taxes also play a role on the demand side. Policies such as investment tax credits, for example, can greatly influence the demand for capital goods. The greatest obstacle to proper use of fiscal policy—both for its ability to stabilize fluctuations in the short run and for its long-run effect on the natural rate of output—is that changes in fiscal policy are necessarily bundled with other changes that please or displease various constituencies.

The same is true for a tax cut for some favored constituency. This naturally leads to an institutional enthusiasm for expansionary policies during recessions that is not matched by a taste for contractionary policies during booms.

In addition, the benefits from expansionary policy are felt immediately, whereas its costs—higher future taxes and lower economic growth —are postponed until a later date.

The problem of making good fiscal policy in the face of such obstacles is, in the final analysis, not economic but political. Fiscal Policy By David N. Categories: Government Policy Macroeconomics. By David N. About the Author David N. Weil is a professor of economics at Brown University. Further Reading Nontechnical Bartley, Robert.

Seven Fat Years. New York: Simon and Schuster, Krugman, Paul. New York: Norton, An attack on the fiscal policy and other aspects of the George W. As we have learned, some government purchases are for goods, such as office supplies, and services.

But the government can also purchase investment items, such as roads and schools. In that case, government investment may be crowding out private investment. The reverse of crowding out occurs with a contractionary fiscal policy—a cut in government purchases or transfer payments, or an increase in taxes.

Such policies reduce the deficit or increase the surplus and thus reduce government borrowing, shifting the supply curve for bonds to the left. Interest rates drop, inducing a greater quantity of investment. Lower interest rates also reduce the demand for and increase the supply of dollars, lowering the exchange rate and boosting net exports.

Crowding out clearly weakens the impact of fiscal policy. An expansionary fiscal policy has less punch; a contractionary policy puts less of a damper on economic activity. Some economists argue that these forces are so powerful that a change in fiscal policy will have no effect on aggregate demand.

Because empirical studies have been inconclusive, the extent of crowding out and its reverse remains a very controversial area of study. Also, the fact that government deficits today may reduce the capital stock that would otherwise be available to future generations does not imply that such deficits are wrong. If, for example, the deficits are used to finance public sector investment, then the reduction in private capital provided to the future is offset by the increased provision of public sector capital.

We start by looking at the role of fiscal policy. The positive correlation between fiscal variables and long-term interest rates previously found in the literature is not robust when we account for cross-sectional dependence.

A standard FE estimator shows that a one percentage point increase in the expected primary deficit to GDP ratio increases interest rates by around 11 basis points, while a 1 percent increase in the expected debt to GDP ratio increases interest rates by around 1. However, the large value of the CSD statistic Looking at columns 2 and 3 we first notice the importance of accounting for common factors.

The response of long-term interest rates to domestic fiscal policy diminishes in both cases. When we allow for heterogeneous response to global shocks with the FAP column 3 , the primary deficit becomes statistically insignificant, while the effect of public debt remains significant.

As for the magnitude, the effect is smaller than the standard FE estimator column 1 : a 1 percent increase in public debt increases long-term interest rates by around 1 basis point.

The coefficients on the other variables also decrease significantly in magnitude. The coefficient on short-term interest rate decreases when using the FAP, indicating that, accounting for cross-sectional dependence, long-term interest rates are less responsive to domestic monetary policy. The result confirms the findings in the literature that central banks have been progressively losing effectiveness in stirring long-term rates.

Giannone, Lenza, and Reichlin , show how in the recent decades long-term interest rates have become more disconnected from country-specific monetary policy stances. The coefficient on GDP growth remains positive but becomes marginally significant. Finally, we find that coefficient on expected inflation becomes insignificant.

We now briefly discuss the results obtained when including the more recent sample. We confirm the importance of accounting for global factors, but the FAP again performs better than the 2FE as shown by the improvement in the CSD statistics from —2.

The coefficients on fiscal and monetary policy are almost unaffected, with short-term rate, deficit and debt maintaining similar magnitude and significance.

Including the latest crisis changes the significance and signs of the coefficient on GDP growth which becomes negative and ceases to be statistically significant. This shows how growth expectations have started to play a stronger role in assessing fiscal sustainability, with downturns impacting negatively borrowing costs. In this section we check how the importance of the domestic idiosyncratic components has been changing over time.

We have shown that, when controlling for global factors, coefficients on domestic variables weaken. We first provide evidence on the changing contributions of the common factors to the total variance in the data. We then show the evolution of the coefficients in the main regression over time and check for possible breaks. In Figure 2 we compute the variance explained by the first three global factors using a rolling window of 20 periods.

The figure report a 20 period rolling window estimate of the proportion of variance explained by the first three principal components. The figure shows that the share of variance explained by the first three global factors tends to be relatively stable over the sample period, with three principal components explaining between 70 and 80 percent of the variance in the data. We notice that the share of variance explained by the first principal component diminishes over time until the crisis, while the share of variance explained by the second factor increases.

After the crisis, the share of variance explained by the first principal component increases up to 60 percent indicating a stronger co-movement of macroeconomic and financial variables in heightened market turmoil, a result found also in different markets Longstaff et al. We now analyze the time varying effect of domestic fiscal variables.

The figures report the rolling window estimates for expected deficit and expected debt obtained from estimating equation 7 with a 20 period rolling window. Dashed lines represent two standard deviation confidence bands. There is a clear downward trend in the coefficients up until the crisis, indicating weakening influence of domestic variables on interest rates.

After the crisis, there is a temporary increase in the importance of domestic fiscal policy. While fiscal deficits do not have any impact through the more recent period, the coefficient on public debt increases but the uncertainties around its estimates also increases due to the large variation observed in debt during this period. We have further analyzed the role played by the crisis by testing for structural breaks in the coefficients interacted with a crisis dummy.

This evidence suggests a possible re-pricing of risk in the aftermath of the global financial crisis [see Sgherri and Zoli for evidence on the EMU]. The results so far indicate that, when we account for heterogeneous response to global shocks: 1 long-term interest rates remain positively related only to public debt; 2 there is mild evidence of increased importance of domestic fiscal policy in the crisis.

Our results stand partly in contrast with previous literature. In particular, past studies have found a significant effect of public deficits on long-term interest rates Ardagna, Caselli, and Lane We show in this paper that properly accounting for global factors and cross-sectional dependence in the estimation is crucial to understand this result.

The omission of such factors leads to overestimating the impact the idiosyncratic component of fiscal policy. Beside lower impact of public deficits, we also find that the effect of public debt on long-term interest rates is smaller compared to previous estimates. Laubach for instance, finds that a 1 percent increase in public debt to GDP leads to an increase in long-term interest rates by 3—4 basis points.

We find that the impact is close to 1 basis point. Within the neoclassical growth model, under the assumption that roughly two-thirds of the increase in public debt is offset by domestic savings, Laubach shows that a 1 percent increase in public debt to GDP leads to an increase in real interest rates by 2.

Giannone and Lenza , using a Feldstein-Horioka regression, show that less than one-fifth of savings in developed countries are retained for domestic investment. Once a lower degree of crowding-out is assumed, we can reconcile our estimates with theory, and generate effects of public debt on real interest rates in the range of 1 basis point Table 5 , columns 3 and 6.

Our results show that the domestic components of fiscal policy play a smaller role in determining long-term interest rates, once we account for global factors. He finds that the effects on interest rates of domestic fiscal policy shocks are rather small compared to those caused by a global fiscal expansion: a change in domestic surplus leads to a 5 basis points reduction of interest rates, while a change in the EMU surplus leads to a 41 basis points decrease in interest rates.

Ardagna, Caselli, and Lane analyze the impact of the world fiscal stance, measured as both the aggregate primary deficit and the aggregate debt, on a sample of OECD countries.

They find that, depending on the specification, the world deficit leads to increase in interest rates between 28 and 66 basis points, while world debt increases interest rates between 3 and 21 basis points. Our estimation strategy is well suited to capture the importance of global factors estimated through principal components.

The lack of an economic interpretation of what these principal components represent is a possible drawback of the estimation strategy.

While a formal analysis of what can constitute these global factors is beyond the scope of this paper, to provide some economic interpretation to these factors, we relate our results to the existing literature and use the FAP estimator to analyze the magnitude and the cross-country differences in the coefficients related to the global factors. As a first step we plot the principal components against macroeconomic aggregates. We find that the first principal components resemble a measure of aggregate global monetary policy.

The second principal component should be a variable which is driven by the same common shocks but not collinear with the monetary stance. As discussed in Technical Appendix A, we find that indeed there is a strong correlation with global fiscal policy stance, a result which is in line with the empirical specifications chosen by the previous literature. As discussed in Technical Appendix B we use the average expected primary deficit [26] and the average expected short term rate of the countries in our sample.

The estimated coefficients on the global factors are indeed quantitatively important and highly heterogeneous across countries see Table 6. In line with previous literature, average deficit is by far more important than the idiosyncratic fiscal components.

Its average effect is in fact around 20 basis points, which is more than ten times larger than the effect of an increase in idiosyncratic primary deficit. Suggestively, coefficients are higher for countries which were less financially integrated at the beginning of the sample or which were characterized by macroeconomic and institutional weaknesses Figure 4.

The table reports the country specific coefficients on the global deficit factor obtained from the estimation of equation 7. The factor is proxied by the average expected budget deficit of the countries in the sample.

The figures report the estimated country specific effect of global deficit. They are correlated with measures of initial capital markets integration, current account imbalances and economic and institutional fragility. The evidence presented so far provides an interesting reading of the recent dynamics of interest rates and useful policy messages.

All together our results show that: 1 using an econometric specification which appropriately accounts for cross-sectional correlation, the importance of idiosyncratic domestic factors is greatly diminished Table 5 ; 2 idiosyncratic factors seem have lost importance over time-with the exception of the crisis period Figure 3 ; 3 the effect of global factors is quantitatively more important Table 6. Loss of importance of idiosyncratic factors in favor of global ones can be attributed to financial and economic integration and better coordination of macroeconomic policies.

Our analysis shows that global factors are highly correlated with global monetary and fiscal policy stance. The compression of long-term interest rates which occurred in OECD countries prior to the crisis could be explained by the fiscal retrenchment which took place among industrialized countries at the beginning of the nineties and the lowering of inflation premia due to a shift to credible inflation targets.

As suggested by the top left plot of Figure 4 , convergence has occurred more strongly in countries less financially integrated at the beginning of the sample. As the coefficients on the second global factor are shown to be related to external vulnerabilities, [28] this can explain why initial convergence of interest rates came to a halt when global conditions suddenly changed. Overall, we can draw the following policy implications.

Furthermore, since domestic policies have small direct impact on interest rates, but rather have an indirect impact through global factors, these spillovers can have large effect on countries characterized by external vulnerabilities. Improvement in the underlying fundamentals and better international policy coordination [29] can therefore help countries gain better control of their interest rates.

In this paper we tackled the issue of identifying the effects of domestic fiscal policy on long-term interest rates for a panel of OECD countries. We use real time data on forecasts to better take into account the forward looking nature of the responses of financial markets.

The strong correlation observed across interest rates in different countries justifies the use of an estimator which takes into account the presence of unobservable global factors.

This methodology allows us to obtain consistent estimates of the parameters and to study the heterogeneity of the cross-country propagation of global shocks. We show that in general two unobserved factors can explain almost 70 percent of the variance in the data.

We find these factors to closely track the aggregate monetary policy and the aggregate fiscal policy stances. Our results show that global factors are not only quantitatively relevant determinants of long-term interest rates, but once introduced in the analysis, they also affect the importance of the idiosyncratic components.

When using the FAP estimation method, the role of domestic fiscal policy variables is largely reduced: public debt is still significant, but contributes by only 1 basis point. We show that the importance of the idiosyncratic factors is time-varying. We show that the role of idiosyncratic factors has been declining over time.

However, the results point also to an increase in the sensitivity of interest rates to domestic debt after the global crisis. As for the role played by global factors, we find, in line with previous literature, that the effects of a global fiscal expansion are by far quantitatively more important than domestic fiscal policy alone, but that they are also significantly heterogeneous across countries. The magnitude of these effects ranges between 5 and 51 basis points with stronger effects for countries that are characterized by external, economic or institutional fragilities.

Our results provide an interpretation of the recent behavior of interest rates in advanced economies. These shocks have triggered a heterogeneous increase in borrowing costs with larger effects for those countries which, while benefiting from the capital markets integration, had also accumulated larger imbalances.

Hence, even if on one hand economic and financial integration and policy coordination reduce the impact of national policies on borrowing costs, on the other hand changes in global conditions expose more vulnerable countries to a sudden reversal of fortunes. The aim of this appendix is to provide more details on the extraction of the factors and present the evidence for their economic interpretation.

As mentioned in Section 4. The principal components are extracted from the variance covariance matrix of W r , which contains the observable left-hand side and right-hand side variables of equation 7 :. A first important decision in our analysis is the determination of the number of factors to include in the regression.

In the empirical literature on factor models, the determination of the number of factors has been a subject of intense research. For example, Forni and Reichlin propose a rule of thumb according to which one should retain the number of principal components that explains more than a certain fraction of the variance, while Bai and Ng present a formal test based on information criteria.

In our case, as shown in Table 4 in the text, the first two components extracted from W r explain about 68 percent of the total variance, with third factor contributing for about 7.

Following the rule of thumb proposed by Giannone and Lenza we decide therefore to include two factors in the estimating equation. A second important point is the economic interpretation of the common factors. To find it we follow economic intuition. It is plausible to think that in integrated capital markets the global factors driving the interest rates must be related to the global availability of funds.

This intuition is well supported by the data. In fact the first two factors extracted from W r are very much correlated with the average expected short term interest rate and with the average expected primary deficit Figure 5. The Figure shows the estimated unobserved factors plotted against their economic interpretation. This implies that the government should use its powers to increase aggregate demand by increasing spending and creating an easy money environment, which should stimulate the economy by creating jobs and ultimately increasing prosperity.

The Keynesian theorist movement suggests that monetary policy on its own has its limitations in resolving financial crises, thus creating the Keynesian versus the Monetarists debate. While fiscal policy has been used successfully during and after the Great Depression, the Keynesian theories were called into question in the s after a long run of popularity.

Monetarists, such as Milton Friedman, and supply-siders claimed the ongoing government actions had not helped the country avoid the endless cycles of below-average gross domestic product GDP expansion, recessions, and gyrating interest rates. Just like monetary policy, fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth.

When the government is exercising its powers by lowering taxes and increasing their expenditures, they are practicing expansionary fiscal policy. While on the surface expansionary efforts may seem to lead to only positive effects by stimulating the economy, there is a domino effect that is much broader reaching. When the government is spending at a pace faster than tax revenues can be collected, the government can accumulate excess debt as it issues interest-bearing bonds to finance the spending, thus leading to an increase in the national debt.

When the government increases the amount of debt it issues during an expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector that may also need to issue bonds at the same time.

This effect, known as crowding out , can raise rates indirectly because of the increased competition for borrowed funds. Even if the stimulus created by the increased government spending has some initial short-term positive effects, a portion of this economic expansion could be mitigated by the drag caused by higher interest expenses for borrowers, including the government. Another indirect effect of fiscal policy is the potential for foreign investors to bid up the U.

While a stronger home currency sounds positive on the surface, depending on the magnitude of the change in rates, it can actually make American goods more expensive to export and foreign-made goods cheaper to import. Since most consumers tend to use price as a determining factor in their purchasing practices, a shift to buying more foreign goods and a slowing demand for domestic products could lead to a temporary trade imbalance.

These are all possible scenarios that have to be considered and anticipated. There is no way to predict which outcome will emerge and by how much, because there are so many other moving targets, including market influences, natural disasters, wars and any other large-scale event that can move markets.

Fiscal policy measures also suffer from a natural lag or the delay in time from when they are determined to be needed to when they actually pass through Congress and ultimately the president.

Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists run into challenges in accurately predicting short-term economic changes. Monetary policy can also be used to ignite or slow the economy and is controlled by the Federal Reserve with the ultimate goal of creating an easy money environment.

Early Keynesians did not believe monetary policy had any long-lasting effects on the economy because:. At different times in the economic cycle , this may or may not be true, but monetary policy has proven to have some influence and impact on the economy, as well as equity and fixed income markets.

The Federal Reserve carries three powerful tools in its arsenal and is very active with all of them. The most commonly used tool is their open market operations , which affect the money supply through buying and selling U. The Federal Reserve can increase the money supply by buying securities and decrease the money supply by selling securities.

The Fed can also change the reserve requirements at banks, directly increasing or decreasing the money supply. The required reserve ratio affects the money supply by regulating how much money banks must hold in reserve. If the Federal Reserve wants to increase the money supply, it can decrease the amount of reserves required, and if it wants to decrease the money supply, it can increase the amount of reserves required to be held by banks.