Academic journal article Atlantic Economic Journal

Government Budget Deficits, Nominal and Ex Ante Real Long-Term Interest Rates in the U.K., 1960:1-1990:2

Academic journal article Atlantic Economic Journal

Government Budget Deficits, Nominal and Ex Ante Real Long-Term Interest Rates in the U.K., 1960:1-1990:2

Article excerpt

I. Introduction

In the economic literature there are two conflicting views regarding the effect of government budget deficits on interest rates. The first view indicates that large government budget deficits increase interest rates, while the other view denies the existence of a significant relationship between government budget deficits and interest rates.

Dwyer |1982~; Plosser |1982, 1987~; Makin |1983~; Hoelscher |1983~; Kormendi |1983~; Mascaro and Meltzer |1983~; Dewald |1983~; Motley |1983~; Aschauer |1985~; Evans |1985, 1987(a), 1987(b)~; Monadjemi |1989~; Giannaros and Kolluri |1989~; Darrat |1989, 1990~; and Findlay |1990~ have provided empirical evidence suggesting that government budget deficits have no significant effect on interest rates.

In contrast, Feldstein |1982~; Hutchinson and Pyle |1984~; Brath et al. |1985~; Tanzi |1985~; Hoelscher |1986~; Tran and Swahney |1988~; Wachtel and Young |1987~; Kolluri and Giannaros |1987~; Zahid |1988~; Holloway |1988~; Thomas and Abderrazak |1988(a), 1988(b)~; Allen |1990~; Cebula |1990(a), 1990(b), 1990(c), 1991~; and Al-Saji |1991, 1992~ have found that large government budget deficits cause high interest rates.

The purpose of this paper is to empirically investigate the effect of government budget deficits on nominal and ex ante real long-term interest rates in the U.K. utilizing an open and closed economy IS-LM framework. It also investigates the validity of the hypothesis that there is a one-to-one relationship between nominal interest rates and the expected rate of inflation, which if it is accurately predicted, increases nominal interest rates but would leave real interest rates constant.(1)

The reason for studying this issue in the context of a major industrialized country like the U.K. is that during the sample period under consideration, the U.K. economy experienced, among other things, a large government budget and international trade deficits. Between 1960:1 and 1990:2, the government budget deficit rose from 746 million pounds to 4,325 million pounds. During the same period, the international trade deficit increased from 52 million pounds to 2,014 million pounds.(2)

A large government budget deficit financed primarily by the sale of government bonds and treasury bills is perceived to cause high interest rates. This, in turn, will reduce private investment, which adversely affects economic growth. Therefore, it is critically important to determine whether a large government budget deficit has a significant or neutral impact upon nominal and ex ante real long-term interest rates.

This paper is organized as follows. Section II discusses the data sources, the theoretical model to be used, and the empirical results. Section III contains a summary of the results and conclusions.

II. Data, Theoretical Model, and Empirical Results

(A) Government Budget Deficits and Nominal Long-Term Interest Rates

An Open Economy IS-LM Model. An open economy IS-LM model is employed here to analyze the impact of government budget deficits upon nominal long-term interest rates. Since the standard IS-LM model for an open economy is quite common to those reading the economic literature, no attempt is made here to infer its workings |Feldstein, 1982; Mascaro and Meltzer, 1983; Evans, 1985; Wachtel and Young, 1987; and Monadjemi, 1989~. In an open economy, the IS-LM model indicates the presence of a relationship between nominal long-term interest rates, R, the expected rate of inflation, |P.sup.e~, the real money stock, MP, the real government budget deficit, DF, the real government spending, GP, and the real balance of trade, XP. This relationship can be represented as follows:

|Mathematical Expression Omitted~

where |e.sub.t~ represents the usual error term. It is expected that |a.sub.1~, |a.sub.3~, |a.sub.4~, and |a.sub.5~ will be positive. |a.sub.2~ is expected to be negative.

The expected rate of inflation |Mathematical Expression Omitted~ is an unobservable variable and data on |Mathematical Expression Omitted~ are not available. …

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