An empirical note on the impact of the federal budget deficit on ex ante real long-term interest rates, 1973-1995.

• Author: Cebula, Richard J.

1. Introduction

   The impact of the federal budget deficit on the rate of interest in the United States has been examined extensively in recent years [2; 3; 4; 5; 6; 7; 8; 9; 11; 12; 13; 14; 15; 16; 17; 19; 20; 21; 23]. Most of these studies focus on the short-term rate of interest, especially the three-month Treasury bill rate or the 4-6 month commercial paper rate. A few of these studies focus on longer-term rates, such as the ten-year Treasury note rate, various corporate bond rates, and 20- or 30-year Treasury bond rates. Those studies that focus on short-term rates generally find that the deficit exercises no significant impact, although there are exceptions [2; 3]. Those studies that focus on the longer-term rates often find that deficits do act to significantly raise those rates.

   Despite the publication of numerous related empirical studies, few studies have investigated the impact that U.S. budget deficits may exercise on ex ante real long-term rates per se. This neglect is unfortunate since traditional macroeconomics generally argues that these long-term interest rates transmit the effects of budget deficits to the "real" side of the economy. This is because the interest-sensitive components of private sector spending, such as business outlays on new plant and equipment and new home construction, are most sensitive to variations in these long-term rates. Furthermore, this literature almost altogether fails to address the deficit-interest rate issue for the U.S. for the second half of the 1980s and the early 1990s.

   Accordingly, this study empirically investigates the impact of federal budget deficits in the U.S. on the ex ante real long-term interest rate yield over the period 1973.2-1995.3. The study deals with quarterly data and is couched in an open-economy loanable funds model. The study period begins with 1973.2 because this quarter marks the collapse of Bretton Woods, whereas it ends with 1995.3 to make the study as current as now possible. To date, empirical studies addressing U.S. budget deficits and interest rates have largely ignored the time period after 1984 or 1985; hence, this study not only provides information on an important but largely neglected long-term U.S. interest rate measure but also information that is more updated/current than that in the existing literature.

2. Model and Data

   The model examined here largely parallels the analyses in Barth, Iden, and Russek [3], Hoelscher [9], and Cebula [4]. The model adopted in this study regards the ex ante real long-term rate of interest as being determined by a loanable funds equilibrium of the following form:

   D + C = S + B (1)

   where

   D = real private sector demand for long-term bonds

   C = real net capital inflows

   S = real private sector supply of long-term bonds

   B = real net borrowing by (budget deficits of) the government.

   In this framework, it is expected that:

   D = D(EARLR, EARSR), [D.sub.EARLR] [greater than] 0, [D.sub.EARSR] [less than] 0 (2)

   S = S(EARLR, PCY), [S.sub.EARLR] [less than] 0, [S.sub.PCY] [greater than] 0 (3)

   where

   EARLR = the ex ante real long-term interest rate

   EARSR = the ex ante real short-term interest rate

   PCY = the change in per capita real GDP

   and where subscripts denote partial differentiation.

   It is hypothesized that, in principle paralleling Barth, Iden, and Russek [3] and Cebula [4], the real demand for long-term bonds is an increasing function of the ex ante real long-term interest rate. Paralleling Hoelscher [9] and Cebula [4], the expected sign on [D.sub.EARSR] is negative because the higher the short-term ex ante real interest rate the greater the degree to which bond demanders/buyers substitute short-term bonds for long-term bonds.

   In principle paralleling Hoelscher [9] and Cebula [4], the real supply of long-term bonds is hypothesized to be a decreasing function of the ex ante real long-term interest rate. The variable PCY is included in the bond supply function to capture any accelerator effects of real GDP changes on aggregate investment demand [9]. It is hypothesized here that, as PCY...