Interest Rates and Budget Deficits

A Study of the Advanced Economies

Kanhaya L. Gupta, Bakhtiar Moazzami

• Publisher: Routledge
• Year: 2005
• Print ISBN:
  9780415101356
• eBook ISBN:
  9781134853892
• Topic: Business
• Subtopic: Business General
• Index: Business

There is widespread belief that the high interest rates of the 1980s and 1990s in the developed world have been caused by high budget deficits. Yet, there is no conclusive evidence to support such a belief. This book systematically examines this and other questions relating to the behaviour of real interest rates in eleven developed countries. The results show that generalizations across the countries can be hazardous and strongly suggests that factors specific to individual countries are still of vital importance.

1
INTRODUCTION

The behaviour of nominal and real interest rates in the developed countries over the last several decades has been the subject of considerable scrutiny and debate. But in spite of the various controversies surrounding this issue, it is rather strange that most of the empirical literature in this area has been confined to the U.S.A. Our aim in this study is to fill this gap to some extent. However, we would like to add that the aim is not only to extend the coverage to more countries, but also to suggest, what we hope, are better ways of answering the questions to be explored.

At a more specific level, we plan to ask some of the same kinds of questions which have been asked over the last decade or so about the behaviour of real interest rates. And we do that for a sample of eleven developed countries. Thus we ask:

(a) How should we measure the ex-ante real interest rates, given that they are generally not observable in most countries?

(b) Do the measured rates remain constant over time?

(c) Do they tend to be equal across the countries? If so, does the equality hold only in the long run?

(d) Does the Fisher hypothesis hold in all countries and in all time periods covered? Once again, does the validity of this hypothesis depend on whether we are dealing with the long term only?

(e) Do the real rates tend to be exogenous in a world characterized by a certain set of variables?

(f) Do budget deficits matter in determining the intertemporal behaviour of the real rates? Do they account for the persistently high rates in the 1980s and persistently lower rates in the 1970s? Would the rates have behaved differently if the time path of the deficits had been different?

(g) Is the answer to one or more of the above questions sensitive to the particular time period covered or to how the real rates are generated or the type of the interest rate used?

Of course, there are other questions one could ask. But given the number of the countries covered in our sample, we confine ourselves to a manageable set of questions.

In order to assist the reader in the reading of our work, we offer a brief summary of the chapters to follow.

Chapter 2. The first major problem about the subject under consideration is that the variable of our inquiry, namely the ex-ante real interest rate, is not directly observable except in the case of index-linked bonds. This means that some proxy must be found. This chapter discusses alternate means of generating them, including the advantages and disadvantages of each method. It also discusses the problems with the real rates obtained from index-linked bonds. Since the real rates used in economic decision making are often post-tax rates, we also comment upon them.

Chapter 3. The estimation methods discussed in the last chapter are used to present estimates of the ex-ante real interest rates for the eleven countries. The interest rates covered are both short term and medium term. These estimates are then used to examine their intertemporal behaviour. For example, were the estimated rates higher during the 1980s than during the 1970s, as is commonly believed? Did their variability differ between different decades? Do the estimates indicate any significant structural breaks?

These rates are further used to examine questions about the international linkages and the equality of the rates across the countries. But before doing that, the chapter presents extensive evidence on the time series properties of the estimated rates. Then using a model which is a combination of Mishkin (1984) and Wickens and Breusch (1988), we test three hypotheses: first, whether the rates are linked internationally; second, whether this linkage is full or partial; and, third, whether the rates are equal internationally. An interesting aspect of the methodology used is that it allows us to test both the long-run and the short-run relationship as well as to allow us to estimate the speed of adjustment of the estimated rates to their long-run equilibrium values.

Chapter 4. This chapter deals with one of the most important hypotheses in monetary economics, namely, the Fisher hypothesis. A distinctive feature of the evidence presented is that it is also based on the methodology used in Chapter 3. In other words, we are able to distinguish between the long-run validity of the hypothesis versus the short-run verification.

Chapter 5. Here we explore the question first discussed in detail by Litterman and Weiss (1985), namely, the question about the exogeneity of real interest rates. This is done using the Granger causality test and the innovation accounting technique. We first test the null hypothesis that the real rate is exogenous relative to a universe that includes money, real output and expected inflation. Then, as an additional test of exogeneity of the real rates, we decompose their variance into components explained by orthogonalized innovations in money, real output and expected inflation.

Chapter 6. From the properties of the real rates, in this chapter we turn to what is arguably the most talked about and controversial policy issue in the literature on interest rates. We are, of course, referring to the role of budget deficits. It has been suggested that in order to appropriately discriminate between the competing paradigms on this issue, we must be able to distinguish between the effects of permanent vis-à-vis transitory changes in budget deficits (Bernheim, 1989). In this chapter we propose a model which allows us to achieve this goal without the necessity to generate such proxies and thus enables us to distinguish between the competing paradigms.

Chapter 7. This chapter provides the most extensive evidence to date on the role of budget deficits on interest rates. This is done in three stages. First, we look at the descriptive evidence on deficits and the estimated rates and check whether the data display any regularities which require explanation. Second, we provide a very brief survey of the existing evidence. Finally, we estimate the model of Chapter 6 and also employ the innovation accounting technique used in Chapter 5. An interesting feature of these results is the simulations done to trace the time path of the estimated rates if the deficit is set equal to zero over the time horizon under consideration.

Chapter 8. Since the evidence is very extensive, no attempt is made in the final chapter to summarize the results. That is done in each chapter individually. However, we simply try to gather together some broad lessons which emerge from our findings and the use of the methodology employed.

2
PROBLEMS OF MEASURING EX-ANTE REAL INTEREST RATES

It was pointed out in Chapter 1 that the relevant interest rates for economic decision making are the post-tax ex-ante real interest rates. Leaving aside the question of taxes for the moment, even the estimation of pre-tax ex-ante real interest rates poses problems because they are not directly observable in general. Even for the index-linked bonds, where such rates are directly observable, there are serious difficulties, as discussed below. This chapter briefly describes the various approaches to the estimation of such rates in the literature and the approaches used by us.

ALTERNATE METHODS OF ESTIMATING EX-ANTE REAL INTEREST RATES

For ease of discussion, we distinguish four approaches:

1 direct estimates from index-linked bonds;

2 survey method based on direct estimates of inflation expectations;

3 standard method using current and/or past rates of inflation to estimate inflation expectations; and

4 the rational expectations approach.

Since the four methods of estimation are relatively well known, our discussion is brief. Clearly, the most attractive solution would be if we could directly observe such rates. In principle, yields on index-linked bonds could provide such a measure. But, unfortunately, as, for example, Wormell (1985), has pointed out there is no commonly agreed method for calculating the real yields on such bonds, and the yields published by brokers and newspapers tend to differ widely. This happens because of the differences in the assumptions made about expected inflation. Generally, two approaches are used to formulate such expectation: either that inflation would continue at a constant rate, starting from a certain date, or that it will continue at a level equal to the average of some recent period. Both assumptions have disadvantages. Therefore, brokers tend to publish yields based on a range of retail price index changes and let the users choose what they like. The result, according to Wormell is that, ‘the yields on index-linked stocks have swung widely since their introduction. This volatility has been a result of not changes in real returns in the economy, but of other, more technical reasons’ (p. 101). Thus, it is clear that even if we had such estimates available for all of the countries in our sample, they would not necessarily provide an accurate measure of the ex-ante real interest rates. But a more practical limitation for us is that such rates are available only for the U.K. and those too only since March 1981. However, just for the sake of comparison with alternate estimates, we would use the available information on these rates in the next chapter.

A rather popular method for estimating ex-ante real interest rates, whether pre- or post-tax, in the United States has been based on the use of survey data on inflation expectations. Of course, once data on expected inflation is given, the rest of the calculations are not that difficult. The main question when this method is used is whether the survey data represent unbiased measure of the inflation expectations, i.e., whether they are consistent with the rational expectations hypothesis. Existing empirical evidence suggests that the survey data on inflation expectations are not an unbiased measure of expected inflation. (See, for example, Baghestani (1992), among others.) In fact, in a recent study, Lahiri and Zaporowski go on to conclude that,

the expected inflation series resulting from the rationall...

Table of contents

• Cover
• Half Title
• Full Title
• Copyright
• Dedication
• Contents
• List of figures
• List of tables
• Acknowledgements
• 1 INTRODUCTION
• 2 PROBLEMS OF MEASURING EX-ANTE REAL INTEREST RATES
• 3 ESTIMATES AND BEHAVIOUR OF EX-ANTE REAL INTEREST RATES
• 4 INTEREST RATES, INFLATION AND TAXES
• 5 ON THE EXOGENEITY OF THE REAL INTEREST RATE
• 6 BUDGET DEFICITS AND INTEREST RATES: THEORY
• 7 BUDGET DEFICITS AND INTEREST RATES: THE EVIDENCE
• 8 SOME LESSONS
• Notes
• Select bibliography
• Index