A note on budget deficits and interest rates: evidence from a small open economy.

• Author: Vamvoukas, George A.

1. Introduction

   The interplay between budget deficits and other economic variables is of great importance to economic policy makers. It is therefore of great concern how macroeconomic policy actions affect budget deficits and how these actions determine the course of economic activity. A related aspect of the argument concerns the links between budget deficits and interest rates. Using annual data of the Greek economy, this paper explores the sensitivity and robustness of the Keynesian and Ricardian equivalence paradigms.(1) Most studies testing the Keynesian proposition and the Ricardian equivalence hypothesis are based on United States data. Hence, there is a need for further investigation of this issue using data from other countries with different structures.

   The empirical evidence on the linkages between government deficits and interest rates has been mixed. For example, Feldstein [13], Zahid [26], Cebula [5; 6], Laumas [19], Abell [1], Miller and Russek [21], Due [9], Raynold [23] argue in favor of the Keynesian proposition (the conventional view) of a positive relationship between government deficits and interest rates. On the other hand, Barro [3], Hoelscher [15], Evans [11; 12], and Darrat [7] refute the Keynesian proposition, supporting the view either that government deficits negatively influence interest rates, or that interest rates and deficits follow independent paths.

   This paper examines the cointegratedness of the time series and estimates the implied Error-Correction interest rate model. Moreover, the paper uses a number of basic diagnostic and specification tests in order to investigate the robustness, consistency and stability of the Error-Correction Model (ECM). In the next section, several issues relating to data and specification are discussed. Section III presents the empirical findings and section IV considers the main conclusions.

2. Data, Specification

   In constructing the interest rate equation, we have taken into account previous empirical work concerning the relationship between budget deficits and interest rates. We have adopted Sim's view [25] and have included in the analysis additional economic variables which have a significant influence on and are influenced by budget deficits and interest rates. The exclusion of these variables from our interest rate model could lead to biased and spurious results. Based on the economic modelling of previous studies examining the links between budget deficits and interest rates, the following interest rate regression equation is considered:(2)

   [INTR.sub.t] = [a.sub.0] + [a.sub.1][RGNP.sub.t] + [a.sub.2] [UNML.sub.t] + [a.sub.3] [INFL.sub.t]

   + [a.sub.4] [BDEF.sub.t] + [a.sub.5] [M.sub.t] + [a.sub.6] [GE.sub.t] + [a.sub.7] [GT.sub.t] + [u.sub.t](1)

   where [a.sub.0], [a.sub.1], [a.sub.2], [a.sub.3], [a.sub.4], [a.sub.5], [a.sub.6], [a.sub.7], are parameters; INTR is the average nominal interest rate on one year yield bonds and treasury bills; RGNP is the real Gross National Product; the unemployment rate series (UNML) is the annual average of the seasonally adjusted monthly unemployment rates; INFL is the inflation rate calculated by the CPI (Consumer Price Index); BDEF is the actual budget deficit in real terms; M is the narrowly defined money stock [M.sub.1] in real terms; GE is current government expenditure on goods and services in real terms; GT is current government transfers in real terms; u is a white noise disturbance term; and t stands for time. We obtain BDEF, M, GE and GT by dividing the nominal data by the CPI.(3)

   In accordance with Barro [2; 3] and other advocates of the Ricardian equivalence hypothesis, we decompose government spending into permanent and transitory components.(4) As Seater [24, 175] pointed out, this decomposition is very important, otherwise "both the deficit and debt variables may have elements of simultaneity bias in them." When the budget deficit is included in an interest rate regression, and at the same time excluding government purchases, this may introduce omitted variable bias. It is possible for statistical results to ascribe to budget deficits effects that should actually be ascribed to government purchases.

   Therefore, when testing the validity of Keynesian and Ricardian equivalence paradigms and properly specifying the interest rate regression (1), we decompose total government spending into permanent and temporary purchases and introduce the GE and GT series. With no decomposition of government spending, it is possible that "the deficit may proxy for transitory purchases and have a significant coefficient even if Ricardian equivalence actually holds"...