Long-Term Interest Rates: The Role of Expected Budget Deficits

Abstract

A relatively simple loanable funds model is utilized to explain the 10-year government bond yield during 1970–86. In the reduced form equation, expected inflation, expected structural deficits as a percentage of GNP, output growth, and liquidity growth appear as exogenous variables. Using alternative measures of expected inflation and expected deficits, the regression results indicate a powerful effect of expected deficits on the 10-year government bond yield. The increase in expected deficits raised bond yields by some 180 basis points by early 1984, and the anticipation of deficit-reduction legislation accounts for about one-third of the decline in yields during 1985–86, according to the model. In alternative experiments, tests are conducted to see whether bond yields “Granger-cause” forthcoming deficits. Our findings are consistent with the view that agents are forward-looking and foresee the direction of major changes in structural deficits.