Working Paper: CEPR ID: DP5793
Authors: Carlo A. Favero; Stefano W. Giglio
Abstract: We study the relationship between the term structure of interest rates and fiscal policy by considering the Italian case. Empirical analysis has been so far rather inconclusive on this important topic. We abscribe such evidence to three problems: identification, regime-switching and maturity effects. All these aspects are particularly relevant to the Italian case. We propose a parsimonious model with three factors to represent the whole yield curve, and we consider yield differentials between Italian and German Government bonds. To take into account the possibility of regime-switching, we explicitly include a hidden two-state Markov chain that represents market expectations. The model is estimated using Bayesian econometric techniques. We find that government debt and its evolution significantly influence the yield of government bonds, that such effects are maturity dependent and regime-dependent. Hence when investigating the effect of fiscal policy on the term-structure it is of crucial importance to allow for multiple regimes in the estimation.
Keywords: Bayesian estimation; Fiscal policy; Regime switching; Term structure
JEL Codes: E0; G0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government debt (H63) | yield of government bonds (E43) |
| debt-to-GDP ratio (H68) | long-term spread between Italian and German government bonds (E43) |
| debt-to-GDP ratio (H68) | medium-term yields (E43) |
| fiscal policy (E62) | medium-term yields (E43) |
| market expectations (D84) | risk premium associated with fiscal policy (E62) |