A Cointegrating approach to budget deficits and long-term interest rates

Abstract

A cointegrating approach is undertaken in this study to determine if there is a long-run equilibrium relationship between budget deficits and long-term interest rates for the United States and nine European countries. The cointegration approach consists of conducting cointegration tests and then testing several hypothesized values for the deficit and price expectations variables. The cointegration results suggest the existence of several significant cointegrating vectors for each of the ten countries, which would seem to appeal to the view of budget deficits having a positive impact on long-term interest rates. The hypothesized values for the deficit and price expectations variables are found to be too strict since the hypotheses are rejected in every case but one.

Notes

¹ As a prerequisite to EU membership, a European country could have a deficit to GDP ratio of no greater than 3%.

² As cited earlier, the impact of budget deficits has been examined for France, Germany, Italy and United Kingdom.

³ Hoelscher includes CHGDP to account for the accelator effects of changes in GDP on D_LF .

⁴ The tables giving the results of the unit root tests are are available from the author upon request.

⁵ The selection criteria are the SBC, AIC and the F-statistic.

⁶ , or the max statistic, is the chosen statistic to determine the distinct number of cointegrating vectors.

⁷ Cebula found 2 significant cointegrating vectors for each the United Kingdom, Germany and Italy.

⁸ The hypothesized values are restrictions placed on the β matrix from the equation, Π = αβ′.

⁹ That is, the estimated coefficient of these variables that would result from estimating Equation 4.

¹⁰ As a way to also test the strong-form version of the Fisher effect.

¹¹ This is to determine if a change in the DEF variable causes a proportional change in i_L .