Government borrowing and tax-adjusted real and nominal interest rates

Abstract

The purpose of this paper is to test for the effect of Federal Government budget deficits on one-year tax-adjusted nominal and real interest rates in an IS-LM-AS model. The results suggest that the specification of the dependent variable is a crucial issue in the debate over the linkage between deficits and interest rates. The evidence shows a positive and significant effect of various measures of the Federal Government deficit and debt on the real tax-adjusted Treasury bill rate in both the levels and the first-differenced equations but not on the nominal tax-adjusted rate. The positive and significant dificit-debt coefficients are also confirmed when the first-differenced equation is estimated by instrumental variables and when the equation is estimated over various time periods. Thus, there is robust evidence of a positive linkage between federal government borrowing and the tax-adjusted real but not nominal interest rates.