Academic journal article Journal of Economics and Finance

An Exploratory Empirical Inquiry into the Impact of Federal Budget Deficits on the Ex Post Real Interest Rate Yield on Ten Year Treasury Notes over the Last Half Century

Academic journal article Journal of Economics and Finance

An Exploratory Empirical Inquiry into the Impact of Federal Budget Deficits on the Ex Post Real Interest Rate Yield on Ten Year Treasury Notes over the Last Half Century

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1 Introduction

The impact of government budget deficits on interest rates has been studied extensively. This literature is especially rich since the early 1980s (Al-Saji 1993; Barth et al. 1984, 1985, 1986; Cebula 1997, 2005, 2013; Cebula and Cuellar 2010; Ewing and Yanochik 1999; Findlay 1990; Gissey 1999; Hoelscher 1983, 1986; Johnson 1992; Ostrosky 1990; Saltz 1998; Swamy et al. 1990; Tanzi 1985; Zahid 1988). Many of these studies find that budget deficits raise longer term interest rates while not significantly affecting short term rates. Since capital formation is presumably much more affected by longer term than by short term rates, it has been argued that budget deficits may lead to the "crowding out" of private investment (Carlson and Spencer 1975; Cebula 1997; Ewing and Yanochik 1999).

During recent years, the impact of budget deficits on interest rate yields has received only limited attention in the lit erahne. Accordingly, in view of the resurgence of large federal budget deficits in the U.S., this study seeks to provide updated evidence as to the effect of the federal budget deficit on the ex post real interest rate yield on 10 year Treasury notes. Unlike most previous studies, this empirical note investigates this deficit/interest rate issue for a period exceeding the last half century, i.e., this study considers the issue in question over a relatively long time period. Focusing on a longer term real interest rate rather than a longer term nominal interest rate on the one hand reflects the fact that investment is probably more influenced by real than by nominal interest rates whereas on the other hand it permits avoidance of the controversy that can arise over the choice/specification of an inflation-expectations variable (Swamy et al. 1990).

Using annual data, this exploratory study investigates the period 1960 through 2012 in order to provide at least preliminary contemporary insights into whether federal budget deficits have elevated real longer term interest rates in the U.S. over an extended time period. Section 2 of this study provides the loanable funds framework adopted, and Section 3 defines the specific variables in the empirical model and describes the data. Section 4 provides the empirical results of autoregressive, two stage least squares (2SLS) estimation for the periods 1960-2012 and 1971-2012. The conclusion is found in Section 5.

2 The framework

Based extensively on Barth et al. (1984, 1985, 1986) and Hoelscher (1986), as well as Al-Saji (1993) and C ebula (1997, 2005), to identify the determinants of the ex post real interest rate yield on 10 year Treasury notes, a loanable funds model is adopted in which the real long term interest rate yield is, assuming all other bond markets are in equilibrium, determined by:

... (1)

where:

D private sector domestic demand for 10 year Treasury notes

MY a measure of the relative magnitude of the domestic money supply (M2), expressed as a percent of GDP

TDY the federal budget deficit, expressed as a percent of GDP

In this framework, it is hypothesized that:

... (2)

where:

RTEN the annual average ex post real interest rate yield on 10 year Treasury notes

RAaa the annual average ex post real interest rate yield on Moody's Baa-rated corporate bonds

RTHREE the annual average ex post real interest rate yield on 3 year Treasury notes

RTXFR the annual average ex post real interest rate yield on high grade municipal bonds; and

CHPCRGDP the change in per capita real il GDP.

According to the model, the private sector demand for 10 year notes is an increasing function of RTEN, ceteris paribus, since bond buyers prefer a higher real rate of return. On the other hand, the higher the ex post real interest rate yield on Moody's Baa-rated corporate bonds, the lower the private sector demand for 10 year Treasury notes as bond buyers at the margin substitute these corporate bonds for the Treasury notes, ceteris paribus. …

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