Budget Deficits, Capital Flows, and Long-Term Interest Rates: Cointegration Findings for the United Kingdom

By Cebula, Richard J. | International Advances in Economic Research, November 1999 | Go to article overview

Budget Deficits, Capital Flows, and Long-Term Interest Rates: Cointegration Findings for the United Kingdom


Cebula, Richard J., International Advances in Economic Research


RICHARD J. CEBULA [*]

This study uses cointegration tools to decide whether a long-term relationship exists between budget deficits and nominal long-term interest rates in the United Kingdom, as previous regression estimates have implicitly assumed. Based on maximum eigenvalue, trace, and likelihood ratio tests, as well as two cointegrating vectors, this study finds that a long-term positive relationship exists between the nominal 20-year government bond rate and the central government budget deficit. (JEL G20)

Introduction

Using regression estimation, recent studies by Saltz [1992, 1998] and Al-Saji [1992, 1993] find that central government budget deficits raise long-term interest rates in the United Kingdom (UK). Ideally, for these studies to have a high degree of credibility, it would be desirable to formally establish, through a tool such as cointegration, that a positive long-term relationship exists between those budget deficits and long-term interest rates in the UK. Accordingly, this study applies cointegration techniques to investigate these variables. The underlying model is an open-economy loanable funds framework whose specification closely resembles the frameworks adopted by the regression studies cited above.

An Open-Economy Loanable Funds Model

In principle, following earlier studies by Barth et al. [1984, 1985], Cebula [1988], and Hoelscher [1986], an open-economy loanable funds model is adopted in which the nominal long-term interest rate is determined by a loanable funds equilibrium of the form:

DD + K = DS + D , (1)

where DD is real domestic private sector demand for long-term bonds, K is real net capital inflows, DS is real domestic private sector supply of long-term bonds, and D is real net borrowing by the central government.

The following behavioral relationships are hypothesized:

DD = DD(LR, P, ersr); [DD.sub.LR] [greater than] 0, [DD.sub.P], [less than] 0, [DD.sub.ersr] [less than] 0, (2)

and

DS = DS(LR, P, PCY); [DS.sub.LR] [less than] 0, [DS.sub.P], [greater than] 0, [DS.sub.PCY] [greater than] 0, (3)

where LR is the nominal long-term interest rate, P is the expected future inflation, ersr is the ex ante (expected) real short-term interest rate, and PCY is the percent change in real gross domestic product (GDP).

In accord with conventional wisdom, it is hypothesized that the real domestic private sector demand for long-term bonds is an increasing function of the nominal long-term interest rate and a decreasing function of expected future inflation. It is further hypothesized that the real domestic private sector demand for long-term bonds is a decreasing function of the ex ante real short-term interest rate. This is because the higher this short-term rate, the greater the extent to which bond buyers substitute short-term bonds for long-term bonds.

It is also hypothesized that the real domestic private sector supply of long-term bonds is a decreasing function of the nominal long-term interest rate and an increasing function of expected future inflation. The variable PCY is included in (3) to help capture accelerator effects of real GDP changes on aggregate investment demand [Hoelscher, 1986; Cebula, 1988].

Substituting (2) and (3) into (1) and solving for LR yields:

LR = LR(P, ersr, PCY, K,D), (4)

where it is expected that:

[LR.sub.P] [greater than] 0, [LR.sub.ersr] [greater than] 0, [LR.sub.PCY] [greater than] 0, [LR.sub.K] [less than] 0, [LR.sub.D] [greater than] 0. (5)

The first three signs follow directly from (2) and (3). Regarding the sign on [R.sub.K], the higher the net financial capital inflow, the greater the extent to anticipate downward pressure on long-term rates since these net capital inflows absord domestic debt issues, including government debt issues [Hoelscher, 1986; Cebula, 1988]. Finally, as conventional macroeconomics argues, central government efforts to finance a budget deficit exert upward pressure on the interest rate as the government competes in the marketplace for funds. …

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