Working Paper: NBER ID: w11574
Authors: Qiang Dai; Thomas Philippon
Abstract: Macroeconomists want to understand the effects of fiscal policy on interest rates, while financial economists look for the factors that drive the dynamics of the yield curve. To shed light on both issues, we present an empirical macro-finance model that combines a no-arbitrage affine term structure model with a set of structural restrictions that allow us to identify fiscal policy shocks, and trace the effects of these shocks on the prices of bonds of different maturities. Compared to a standard VAR, this approach has the advantage of incorporating the information embedded in a large cross-section of bond prices. Moreover, the pricing equations provide new ways to assess the model's ability to capture risk preferences and expectations. Our results suggest that (i) government deficits affect long term interest rates: a one percentage point increase in the deficit to GDP ratio, lasting for 3 years, will eventually increase the 10-year rate by 40--50 basis points; (ii) this increase is partly due to higher expected spot rates, and partly due to higher risk premia on long term bonds; and (iii) the fiscal policy shocks account for up to 12% of the variance of forecast errors in bond yields.
Keywords: Fiscal Policy; Interest Rates; 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 deficits (H62) | long-term interest rates (E43) |
| deficit-to-GDP ratio (H68) | long-term interest rates (E43) |
| fiscal policy shocks (E62) | bond yields (E43) |
| fiscal policy changes (E62) | long-term interest rates (E43) |
| taxes (H29) | long-term interest rates (E43) |
| expected future short rates (E43) | long-term interest rates (E43) |
| risk premia (G22) | long-term interest rates (E43) |