Academic journal article Journal of Economics and Economic Education Research

Empirical Investigation of the Relationship between Long Term Interest Rate and Government Debt and Deficit Spending

Academic journal article Journal of Economics and Economic Education Research

Empirical Investigation of the Relationship between Long Term Interest Rate and Government Debt and Deficit Spending

Article excerpt

INTRODUCTION

Of importance for the economy of a country is the role government spending plays in influencing long term interest rate and hence investment and growth. It is generally recognized that the central bank has a direct influence on short term interest rate, which is the main reason that studies in the literature focus on long term interest rate, as measured by 10-year bond rate, and how it may be affected by government debt and deficit spending. It is argued that debt and deficit spending leads to an increase in long term interest rate which negatively influences investment by the public sector and therefore economic growth. This is explained as being due to reduced availability of funds (caused by government excessive borrowing) for the private sector. However, it is not clear from the literature if debt or deficit spending leads to an increase in long term interest rate and thus curbs investment and economic growth. Hence, more empirical studies are needed in this regard.

How to induce economic growth at the time of a depression or recession is of fundamental importance for the economy of a country. Economists are mixed on this issue. There are those that argue that government borrowing and spending would create jobs and induce economic growth which would lead us out of the recession. Conservative economists on the other hand argue that government spending causes high interest rates which in turn curbs investment and economic growth. Those that argue that government spending induces growth point out that in a depressed economy the private sector is saving more than investing and hence when the government borrows, it is not competing with the private sector for money. Therefore, borrowing under such a circumstance does not cause an increase in interest rate and can only stimulate the economy by increasing employment and demand. Because of the importance of this contrasting economic points of views on policy making by a government, it is essential to determine empirically if government spending has an effect on long term interest rate.

In this study, the authors test this hypothesis by using time series analysis to determine if there is a functional relationship between deficit spending and interest rate in five industrialized countries, namely, the United States, the United Kingdom, Germany, France, and Japan.

RELEVANT LITERATURE

In a study on determinants of long-term interest rate yields in the US, Cebula (2008) using an error correction model reported that there was a possible bidirectional relationship between budget deficit and interest rate yield on tax-free municipal bonds. Also, short term interest rate had a positive effect on long-term rates. Krueger (2003), Cebula (1991), MacAvoy (2003), Friedman (1978), and Meyer (1975) among others have suggested that government budget deficit can lead to what is termed "crowding out" of private investment due to an increase in long-term interest rate. On the other hand, Krugman (2012) argued that government borrowing and budget deficit during an economic downturn or recession has no effect on long-term interest rate and crowding out of private investment. This is so since in a depression the private sector is not borrowing to invest.

Hoelscher (1986), based on an empirical study, reported that government deficits caused long-tem interest rate (measured as yield on 10-year treasury bonds) to rise. An earlier study by Hoelscher (1983) showed no association between budget deficit and long term interest rate for the United States. Other studies in the literature (Making (1983), Motley (1983), Canto and Rapp (1982), Dewald (1983)) reported that deficits had no effect on short-term interest rates as measured by one-year or less treasury bills. Dewald (1983) and Mascaro and Meltzer (1983) reported that there was no relationship between deficit spending and long-term interest rates.

Keith (2005) argued that usually less developed countries show a link between high deficit spending and high inflation. …

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