The Effect of Deficits

The Office of the Assistant Secretary

for Economic Policy

U.S. Treasury Department

For sale by the Superintendent of Documents, U.S. Government Printing Office

Washington, D.C. 20402


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TABLE OF CONTENTS

PART I: GOVERNMENT DEFICIT SPENDING AND ITS EFFECTS ON PRICES 

 OF FINANCIAL ASSETS

 BACKGROUND AND COVERAGE....................................... 1

 SOME ASSERTIONS ABOUT THE EFFECTS OF DEFICITS ON THE ECONOMY...3

 Short-term financial effects................................ 4

 Effects of deficits on cyclical recovery.................... 5

 EFFECTS OF DEFICITS ON INTEREST RATES......................... 7

 Deficits and interest rates in a simple Keynesian framework..7

 The role of bonds........................................... 8

 Some modifications of the Keynesian framework............... 9

 The treatment of wealth.................................... 10

 Comments on empirical evidence............................. 12

 DEFICITS AND EXCHANGE RATES.................................. 13

 DEFICITS, INFLATION AND THE MIX OF OUTPUTS................... 15

 A digression on crowding out............................... 17

 INCENTIVE EFFECTS............................................ 18

 POTENTIAL GROWTH AND THE STRUCTURAL DEFICIT.................. 19

 A SHORT NOTE ON THE LONG RUN................................. 21

 CONCLUSIONS.................................................. 23

PART II: THE EFFECT OF FEDERAL DEFICITS ON INTEREST RATES: 

 A SURVEY OF THE LITERATURE

 INTRODUCTION................................................. 28

 SOME RECENT SURVEYS OF THE DEBATE............................ 28

 MEASURING THE REAL DEFICIT AND DEBT.......................... 30

 MEASURING THE REAL INTEREST RATE............................. 33

 ECONOMETRIC TESTS OF THE EFFECT OF DEFICITS ON INTEREST RATES. 36

 THEORETICAL RESULTS FROM BASIC KEYNESIAN ANALYSIS............ 42

 THE KEYNESIAN INVESTMENT AND CONSUMPTION FUNCTIONS........... 43
TABLE OF CONTENTS

(Cont.)

 THE EFFECT OF WEALTH IN DEFICIT/INTEREST RATE ANALYSIS...... 43

 DEMAND FOR MONEY IN KEYNESIAN MODELS........................ 44

 QUANTITY THEORY CRITICISM OF KEYNESIAN MODELS............... 45

 LOANABLE FUNDS ANALYSIS..................................... 46

 CROWDING-OUT................................................ 46

 IMPLICATIONS OF GROWTH IN THE FEDERAL DEBT.................. 48

 POTENTIAL INSTABILITY....................................... 49

 MONETIZATION OF THE DEFICIT................................. 50

 EFFECT OF WAGE-PRICE BEHAVIOR IN DEFICIT/INTEREST

 RATE ANALYSIS.............................................. 52

 RELATIVE PRICE EFFECTS OF TAXES IN DEFICIT/INTEREST

 RATE ANALYSIS............................................. 52

 RATIONAL EXPECTATIONS....................................... 52

 CONCLUSION.................................................. 53

 REFERENCES.................................................. 54

PART III: INTEREST RATES AND THE FEDERAL DEFICIT: 

SOME EMPIRICAL TESTS

 INTRODUCTION................................................ 63

 EXTENDING THE FELDSTEIN-ECKSTEIN ANALYSIS................... 63

 RESPECIFICATION OF THE DEFICIT/INTEREST RATE MODEL.......... 69

 EMPIRICAL RESULTS........................................... 74

 CONCLUSIONS................................................. 82

 REFERENCES.................................................. 83
PART I

GOVERNMENT DEFICIT SPENDING AND ITS EFFECTS

ON PRICES OF FINANCIAL ASSETS
PART I

GOVERNMENT DEFICIT SPENDING AND ITS EFFECTS 

ON PRICES OF FINANCIAL ASSETS

BACKGROUND AND COVERAGE

The current international concern among policymakers with 

present and projected levels of budget deficits is of relatively 

recent origin. Following the first oil crisis there was a general 

increase in budget deficits, but no great anxiety about their 

economic effects was evident initially. However, in 1975, as the 

industrial economies were emerging from the world-wide slump, the 

term "crowding out" gained popularity in the financial press.

The celebrity of this term was a gauge of heightened public 

uneasiness about the ill effects that growing budget deficits 

might have on economic performance.

In response to these concerns, beginning about 1976, budget 

policy was directed toward bringing government deficits relative 

to GNP down to pre-1973 levels. Success has been only partial. 

Restrictive fiscal policies in 1976-77 resulted in a reduction of 

budget deficits within the OECD area by about 1 percent of GNP. 

But, in 1978, the sluggish recovery of the world economy prompted 

the adoption of a program of coordinated fiscal action among OECD 

countries and the Bonn Summit agreement on more expansionary 

policies (the "locomotive" initiative). Further modest increases 

in deficits began in that year, so that on the eve of the second 

oil shock in late 1978 the general government deficit in the OECD 

area was some 2 percent of GNP more than at the beginning of the 

decade. 

The overall policy response to the second oil shock was 

meant to be less accommodative than to the first one. That is, 

the policy was designed to prevent higher oil prices from being 

built into domestic price expectations, even at a short-run cost 

of reduced output and employment. But while monetary policy in 

many OECD countries turned restrictive in 1979-80, success in 

reducing government expenditures proved much more elusive, in 

part because of the downturn in output and employment. Combined 

budget deficits of the seven Summit countries which dropped to 

their late 1970's low of 1.7 percent of GNP in 1979, started 

climbing rapidly to reach 3.7 percent in 1982. The OECD forecast 

for the current calendar year for these countries is a deficit 

of about 4.5 percent of their GNP. 

Rising concerns with deficits center, however, not so much on

current deficit-to-GNP ratios (which are virtually the same as in 

1975 -- the first year of the recovery from the previous recession),

but on the prospective deficits. In popular discussions deficits 

have been traditionally viewed as primarily affecting macroeconomic 

targets of aggregate demand and price stability. But, whatever
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are the merits of these rather restrictive interpretations of 

the role of budget deficits as automatic or discretionary stabilization tools, questions about the effects of government deficit 

spending on long-term real economic growth recently have become 

a focus of attention and controversy. 

These effects of government deficits are by no means unambiguous, for even on a most rudimentary level of analysis the 

answer would depend, for instance, on whether deficits are caused

by spending increases or tax cuts, or whether they are financed 

by monetization of the debt or by sale of government debt to the 

public. Similarly, conclusions may vary with such considerations 

as the composition of government spending that the deficits in 

question are supposed to finance; the kind of taxes contemplated 

as a substitute for deficit financing; the openness of a country's 

capital markets to foreign investors; public expectations generated 

by a prospect of continuing deficits; behavioral attitudes as 

reflected in, among others, saving habits; and a host of institutional arrangements determining the adaptability of labor, product 

and asset markets to changing economic conditions, all of which 

influence the effects of deficits on the allocation of resources 

within the private sector. 

Although the relationship between budget deficits and economic growth is complex, the problem may be made analytically 

and empirically tractable by phrasing the discussion in terms of

prices. Thus, often the analysis is reduced to the question of 

the link between budget deficits and the rate of inflation and 

the prices of financial assets, as exemplified by interest or 

exchange rates. Such analyses imply that the connections between 

interest rates and investment or saving (or between the exchange 

rate and exports or imports), and between real capital accumulation and economic growth are thought to be fairly well understood. 

Therefore, if a link between budget deficits and prices of financial assets could be established, a conceptual short-cut supposedly 

would allow the analyst to deduce the effects of budget deficits 

on selected macroeconomic aggregates themselves. 

The main purpose of this paper is to review the issue concerning the effects of government deficit spending on interest 

rates, and to some extent on exchange rates. Frequently encountered assertions about the causal links between deficits and 

prices of financial assets will be critically examined and evaluated. More specifically, an attempt will be made to demonstrate 

that theoretical conclusions about these links have no universal 

validity but depend crucially, instead, on the time horizon of 

the analysis, the institutional and behavioral assumptions underlying the analytical model used, the accompanying circumstances

and policies postulated and the size of various economic parameters 

estimated or assumed. In reviewing assertions about the economic 

effects of budget deficits, some of the concepts frequently (and 

rather loosely) used in popular discussion will be clarified,
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empirical evidence, to the extent that it exists and is germane 

to the issues discussed, will be presented and the relationship 

between budget deficits and a number of economic variables will 

be examined rather extensively within alternative frameworks of 

economic analysis. 

SOME ASSERTIONS ABOUT THE EFFECTS OF DEFICITS ON THE ECONOMY

Assessments of the impact of budget deficits on interest 

(and exchange) rates vary from "crucial" to "none." As indicated 

earlier, contradictory assessments can result from a number of 

causes. 

For example, one analytical framework maintains that there 

is absolutely no difference between higher deficit spending and 

spending fully financed by additional taxes. According to this 

line of argument government borrowing is a perfect substitute for

taxation: personal income that is not taxed enters the saving 

stream, rather than being consumed, thus giving rise to an increase 

in supply of loanable funds equal to the incremental increase in 

demand for such funds attributable to additional government 

spending. The argument is, of course, symmetrical. An increase 

in taxes accompanied by a reduction in government borrowing 

requirements of the same amount shifts both the supply and demand 

curves for loanable funds to the left equally. Therefore, there 

is no impact on the interest rate whether government spending is 

financed by taxes or borrowing. 

At the other extreme is the claim that there is no substitution whatsoever between taxes and government borrowing. This 

assertion relies on the supposition that personal income that is

not taxed is devoted in its entirety to increased consumption. 

As a consequence, additional government borrowing is not accompanied by increased private savings. Thus, an incremental demand 

for loanable funds in conjunction with their unchanged private 

supply inevitably results in an upward pressure on interest rates. 

In the same vein, an assertion is frequently heard that the 

existence of arbitrage in international financial markets ensures 

that capital flows respond instantaneously to incipient interest 

rate differentials among otherwise similar financial instruments 

denominated in various currencies. Therefore, to the extent that 

government borrowing does exert upward pressure on interest rates, 

it must also contribute to an appreciation of a currency generated 

by interest-rate-induced capital inflows. 

A competing line of reasoning, which introduces expectational 

elements into the analysis, leads to the opposite result. Since 

deficit spending, as a reflection of lax fiscal discipline, gives 

rise to fears about future monetization of public debt, expectations
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of a currency depreciation in the future cause capital outflows 

into other currencies, thus making these expectations selffulfilling. 

° Short-term financial effects

The impact of budget deficits on prices of financial assets 

is often explained in terms of very short-term financial flows. 

Although they have superficial plausibility and internal logic, 

such explanations are, as a rule, based upon extremely simplified 

and partial analyses. Thus, blatantly contradictory conclusions 

about the effect of government borrowing on interest and exchange 

rates can result because of the extremely short-run focus of the 

analysis and reliance on the "other things being equal" simplification. For instance, it cannot be denied that, generally, a 

surge in Treasury financing on a given day or week is likely to 

push up interest rates higher than they would be otherwise. It is 

also likely that higher interest rates may attract capital from 

abroad and result in appreciation of the currency. Similarly, 

higher disposable income or larger corporate cash flow resulting 

from a personal or corporate tax cut, respectively, can be expected 

to be translated into larger cash balances held in the form of 

demand deposits. This would mean an increase in banks' liquidity 

and, consequently, a downward pressure on interest rates. 

However, it must be recognized that these effects, even if 

they do in fact occur more or less systematically, are of very 

short-lived and reversible nature. At most it can be said that 

they describe reactions of financial markets to short-term excess 

flow demand or supply that must eventually (and rather rapidly) 

be eliminated by adjustments in the size and composition of 

holdings of financial and real assets by the private sector. In 

other words, the assumption of "other things being equal" can be 

justified in this context only in the very short run. As soon as 

people realize that the government's fiscal policies have changed, 

they will attempt (not always successfully) to adjust their economic behavior accordingly. 

A failure to take account of the inherently short-term nature 

of the "other-things-being-equal" simplification can lead to 

absurd inferences. It has been observed, for instance, that tax 

refunds tend to coincide with a marked reduction in consumers' 

gross credit outstanding, implying that these refunds are used to 

improve consumers' net financial position. It would be patently 

incorrect, however, to infer from the observed pattern that tax 

cuts, i.e., additions to consumers' disposable income, always 

result in an equal increase in saving and have no effect whatsoever on consumption. Even in the very short run the elasticity 

of spending with respect to income is neither zero nor infinite. 

Thus, even using the most simple short-term partial equilibrium 

framework of analysis in which expectations play no role, one cannot make theoretically supportable assertions about the magnitude
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or perhaps even the direction of the effect of increased government 

borrowing on interest rates. 

The same is true, perhaps even more so, with respect to the 

short-run determinants of exchange rates. For example, even if 

one should uncritically accept that increased government borrowing 

does contribute to higher interest rates, it is by no means selfevident that a currency appreciation follows. The theory of 

international financial arbitrage (as reflected in the so-called 

"Fisher open" formula) recognizes only that interest rate differentials among currencies tend to equal the corresponding annualized forward exchange rate premiums or discounts. If the interest 

rate differential, say, between the dollar and the yen, widens

in favor of the dollar, the only thing certain is that the dollar 

forward premium will increase (forward discount will contract). 

This very definitely does not mean that the dollar will appreciate 

relative to the yen. In fact, in order to satisfy the interest 

parity condition, while the forward dollar appreciates, the spot 

dollar may have to depreciate relative to the yen. But, in any 

event, the short-term impact of increased government borrowing

on the exchange rate cannot be unambiguously established by 

theoretical reasoning alone. 

Direct examination of data on deficits and interest and 

exchange rates has not helped much to establish the effects of 

government borrowing on the prices of financial assets. There is 

simply no discernible correlation between changes in government 

borrowing and changes in either interest or exchange rates. This 

lack of correlation is not particularly surprising. One reason 

is that, in fact, things do not remain equal for very long.

While changes in government borrowing requirements are relatively 

mild and occur rather slowly, a variety of constantly shifting 

factors influence interest and exchange rates, thus accounting 

for their much greater volatility. Furthermore, monetary 

authorities customarily try to suppress or moderate the volatility 

of prices of financial assets by intervening in money and foreign 

exchange markets, thus rendering the task of discerning a shortterm empirical relationship between budget deficits and interest 

or exchange rates even more difficult. 

Finally, whatever these short-run effects are, they have 

minimal influence on the longer-term evolution of real economic 

variables. While clearly of great significance to participants 

in financial markets, the causal link between short-term changes 

in government borrowing requirements and transitory responses of 

prices of financial assets is of a relatively minor importance 

for formulation of economic policy. 

° Effects of deficits on cyclical recovery

Some analysts assert that high current deficits will prevent 

or abort the ongoing economic recovery. The argument behind 

this assertion is that big deficits cause high interest rates;
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high interest rates depress expenditures for business investment, 

housing, autos, and output of other interest sensitive industries; 

and the economy cannot recover unless those industries recover. 

The conditions under which big deficits do or do not cause high 

interest rates will be examined at length in later sections. 

But even if big deficits cause high interest rates, this 

argument is very questionable because inadequate demand for some 

categories of output need not prevent a recovery if expenditures 

for other categories of output (such as consumption of nondurables 

or defense spending) are sufficiently large. Recovery depends on 

total production and sale of goods and services, rather than particular categories of goods and services. Large deficits do not 

reduce total economic activity. Depending on economic conditions 

(including the rate of money growth), the current deficit may

put some upward pressure on interest rates or other prices, but 

this would indicate that there is more than enough, rather than 

too little, demand for the available supply. 

There is no economic theory to support the assertion that 

a large current deficit will depress the economy. At most, a 

large deficit that puts upward pressure on the interest rate may 

contribute to a bias in the composition of total demand against 

the output of interest sensitive industries. The extent to which 

this bias will be pronounced is an empirical matter. 

Another assertion is that large expected future deficits 

will prevent the recovery. The argument behind the assertion is 

as follows. Future deficits make expected future interest rates 

high. That keeps present long-term interest rates high, because 

today people will not lend long term at rates that are below the 

rate they expect to obtain several years from now. This argument 

implies that interest rates are higher than the level required to 

finance the current deficit, given current available loanable

funds (savings). 

One version of the argument is that prospective deficits 

result in higher expected inflation, which results in expected 

higher nominal interest rates in the future, thus causing higher 

nominal rates now. But even if future deficits cause higher 

expected inflation (which is by no means self-evident), this 

argument claims that nominal -- not real -- interest rates rise.

However, in a rational world high nominal rates should not restrain 

investment unless expected real rates also rise. 

Another version of the argument, in terms of real interest 

rates, is rather convoluted. It goes as follows. The current 

(i.e., FY 1984) deficit does not depress the 1983 economy, and 

the expected 1988 deficit will not depress the 1988 economy. But 

the expected 1988 deficit is so large, given the expected 1988 

private demand for loanable funds, that it results in an expected 

interest rate in 1988 that is so high it impedes a return to full
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employment in 1983. Arbitrage between present (1983) and future 

(1988) interest rates then keeps 1983 long-term interest rates 

higher than is consistent with economic recovery in 1983. 

This argument is questionable for two reasons. First, it 

assumes that lenders and borrowers make very different predictions. Lenders are influenced by the prediction of future high 

interest rates in a strong economy. In contrast, borrowers who 

would invest in plant and equipment are assumed to reject that 

prediction -- acceptance of it would lead them to invest today, 

even though rates are high, because of the good prospect ahead 

in 1988. Second, if lenders will not lend at long term then it 

would appear they would lend their funds at short term, thus 

driving down short-term rates and contributing to the recovery 

that way. In any case, these arguments that current or future 

deficits prevent recovery are flawed. 

EFFECTS OF DEFICITS ON INTEREST RATES

The foregoing discussion of the likely effects of government 

deficits on the prospects for recovery assumes, albeit not without 

caveats, that government deficits cause high interest rates. The 

validity of this assumption will now be examined. The following 

sections will reveal that the extent to which deficits affect 

interest rates in the medium term is a question for which mainstream conventional economic theories have only ambiguous answers. 

° Deficits and Interest Rates in a simple Keynesian framework

Perhaps the most widely-used approach for analyzing shortand intermediate-run effects of deficits on interest rates is 

Keynesian economic theory. The Keynesian tradition of economic 

analysis has produced a set of conceptual tools which provide a 

framework for analyzing the links between government policy and 

other macroeconomic variables. 

Apart from the special case of the liquidity trap, which is 

discussed below, the basic Keynesian approach gives the result 

that an increase in the deficit brought about either by an increase 

in government spending or a reduction in taxes has the effect of 

raising interest rates. The logic of this result is as follows. 

First, the increase in the deficit increases aggregate demand for 

final output. In the case of more government spending, the 

additional spending adds directly to demand. In the case of a

tax cut, the income that people do not have to pay in taxes 

increases their spending. 

Thus, the larger deficit increases final demand and raises 

nominal GNP. In the Keynesian analysis if the economy is operating 

at a low level of activity the nominal increase will come primarily 
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through an increase in real GNP, while if the economy is near 

full employment of resources the increase will primarily be in 

prices. With a higher nominal GNP the volume of economic transactions in nominal terms is greater, with the result that people 

need more money to carry out the transactions. Hence, the expansion of 

the deficit increases the demand for money. 

Assuming that the central bank does not accommodate this 

increase in money demand by increasing the growth rate of the 

money supply, it is necessary for the velocity of money to rise

to meet the enlarged transactions demand for money. This comes 

about through a rise in interest rates. The enlarged transactions 

demand for money causes interest rates to rise as transactors are 

willing to pay more for the use of money. At the same time, an 

increase in interest rates makes money less attractive as an 

asset relative to other interest-bearing assets, because the 

interest rate on money is generally less than that on other 

assets, so money demanded for asset holdings falls. This decline 

in money demand induced by higher interest rates offsets the 

increase in money demanded for transactions, and so interest 

rates stop rising when the demand for money is brought into 

balance with the money supply. 

° The role of bonds

The discussion presented above shows that in the most basic 

Keynesian framework an increase in the deficit brought about by a 

more expansionary fiscal policy without an increase in the money 

supply tends to raise interest rates. The basic Keynesian framework can be elaborated by introducing government bonds into 

the analysis in at least two ways. In both cases the bonds are 

regarded as wealth and the bond effect reinforces the tendency of 

the higher deficit to raise interest rates. 

First, the bonds are assumed to be a form of wealth which 

substitutes for the wealth embodied in real capital. Under this 

assumption, additional government bonds issued to finance an 

additional deficit thus are perceived to increase wealth. As 

wealth (substitutes for capital), the new bonds have the effect 

of increasing aggregate private consumption spending (reducing 

saving). This increase in consumption is another addition to 

final demand, and following the same logic as before, the increase 

in aggregate demand raises the demand for money and causes an 

increase in interest rates. This bond effect reinforces the 

increase in government spending or the reduction in taxes to 

raise demand and thereby raise interest rates. 

A second way in which the increase in bonds can raise interest rates is that the bonds can affect money demand directly. 

The presence of additional bonds in the economy increases the

ratio of bonds to money in investors' portfolios. In response,
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people attempt to increase their money holdings relative to

their bonds by selling bonds. This drives up interest rates, and 

interest rates continue to rise until the bonds have become so 

attractive that people are willing to hold them. 

The foregoing analysis shows that the typical Keynesian 

result of an increase in the deficit is a rise in interest rates. 

However, a special case in which the fiscal expansion does not 

raise rates is the case of the liquidity trap. The liquidity 

trap is a situation in which people believe that interest rates 

are so low that they cannot fall further. Indeed, in this situation, interest rates are expected to rise and the prices of 

assets (such as bonds) are expected to fall so low that an asset 

purchaser can expect to sustain a capital loss which counterbalances the interest earned on the asset. Fearing capital 

loss, people hold money and other very liquid assets rather

than long-term assets. Thus, an increase in the demand for 

money for transactions purposes can be met simply by drawing 

down enlarged holdings of money without any rise in interest 

rates. Hence in this case an increase in the deficit does not 

raise interest rates. The practical significance of the liquidity trap, which is believed to occur mostly in depressions, is a

subject of dispute. 

° Some modifications of the Keynesian framework

The value of the Keynesian paradigm for practical policy 

analysis depends upon the extent to which it accurately and 

completely models economic reality. To the extent that the 

Keynesian model abstracts from important relationships, it may 

offer inaccurate predictions about the effect of deficits upon 

interest rates. 

Indeed, it appears that the Keynesian model excludes important economic effects that may well dominate the results in 

certain circumstances. For one, the demand for money may decline 

when there is a rise in inflation expected in the near future. 

This is because inflation reduces the real value of money holdings. 

Given this effect, an increase in aggregate demand brought about 

by expansive fiscal policy and higher deficits need not raise 

interest rates, since people may perceive the additional aggregate 

demand as potentially inflationary and reduce their demand for 

money to be held as an asset. In essence the rise in expected 

inflation has the same effect as an increase in the money supply. 

Another effect upon the demand for money is the effect of 

the business cycle. An increase in demand for output stimulated 

by fiscal policy may induce a cyclical expansion. In an expansion 

people have more confidence in their immediate future; hence they 

are more willing to invest in long-term capital and they have
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less need to hold money or other short-term liquid assets to 

protect themselves against risk. In such a situation the demand 

for money to be held as an asset falls, and this tends to reduce 

interest rates. 

A very important set of considerations comprises incentive 

effects of a marginal tax rate cut. Even though taking these 

effects (sometimes referred to as "supply-side" effects) fully

into account is certain to affect radically the conclusions 

yielded by traditional Keynesian analysis, this paper can give 

such incentives only the most rudimentary treatment rather than 

thorough analysis. 

Incentive effects of tax rate cuts can operate not only in 

the long run, but over shorter periods such as a business cycle 

as well. The influence of supply-side effects on real interest 

rates is ambiguous. For instance, a marginal tax rate cut which 

raises the deficit can stimulate the supply of real output and 

induce a cyclical expansion in which the demand for money falls 

and consequently interest rates fall too. This supply-side effect 

complements the demand-side effect outlined in the previous paragraph in which a tax cut or other fiscal measure was perceived

to stimulate a cyclical expansion by raising demand. 

Another possibility is that the marginal tax rate cut could 

lower real before-tax interest rates by raising the after-tax

real rate of return. The rise in the after-tax return can be 

expected to induce increased investment, which increases the 

intensity of capital and lowers its marginal productivity, thus 

tending to reduce real before-tax interest rates. 

In contrast, a marginal tax rate cut can raise the profitability of capital investment and the after-tax return to capital, 

and have the effect of stimulating innovation. Additional innovation raises the marginal productivity of capital, and since 

the real before-tax interest rate is ultimately determined by 

the productivity of capital, a tax cut which raises capital 

productivity leads to a higher real interest rate, both before 

and after tax. 

° The treatment of wealth

The foregoing discussion has dealt mostly with extensions 

to and modifications of the basic Keynesian framework. However, 

another school of thought derives significantly different conclusions regarding the effects of deficits on interest rates, 

even in the short or intermediate run. As mentioned earlier, 

some economists argue that bonds issued by the government are not 

perceived as net wealth by those who hold them. As discussed 

below, if these bonds are not considered to be wealth, a large 

part of the traditional Keynesian approach must be called into 

question. 
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The argument that government bonds are not wealth is based 

upon the fact that the bonds must be redeemed or refinanced at

a later date. If the bonds are redeemed by a general increase in 

taxes, taxpayers, on average, face a future tax liability, and 

this liability offsets, at least in part, the wealth embodied in 

the bonds. Similarly, if the bonds are monetized in the future, 

the money created to redeem them will create future inflation, 

and this will reduce the future purchasing power of money and 

offset the wealth embodied in the bonds. In these cases rational 

individuals will adapt their saving behavior to achieve their 

desired accumulation of real assets. It is only if the bonds are 

indefinitely refinanced by more bonds that the future tax liabilities or the inflation and its attendant loss of purchasing 

power are avoided. 

While in the aggregate government bonds are certainly not 

wealth, many researchers argue that in practice, for a number of 

reasons, bonds may be perceived as wealth by their holders and 

therefore the bonds should be regarded as wealth for the purpose 

of analysis. For one thing, people may not recognize the future 

tax liability implied by the bonds. Or they may consider it to 

be so far into the future that they either discount it substantially, or they presume they will not be alive and future generations will have to bear the burden of paying off the liability. 

Moreover distributional effects may be important; people other 

than those who own the bonds may have to redeem them. In particular, those who hold bonds may have a higher propensity to

save and invest than those who will pay future taxes to redeem 

the bonds. To the extent that government bond-holders do not 

face a future liability, they will tend to regard the bonds as a 

form of wealth substituting for real capital, and in the aggregate 

the bonds will elicit behavioral responses having the same effect 

as an increase in wealth. 

When the idea that government bonds are not considered wealth 

is incorporated into the Keynesian model the results change significantly. For example, if bonds are not viewed as wealth, the

effect (discussed earlier) of additional bonds in increasing 

consumption spending, and thereby increasing overall spending and 

interest rates, disappears, since this effect is based upon the 

bonds being perceived as wealth. Similarly the effect of additional bonds in raising directly the demand for money and interest 

rates also disappears, since if bonds are not wealth they do not 

affect people's portfolios, and there is no need for individuals 

to adjust their portfolios when the number of bonds in the economy 

increases. 

If bonds are not perceived as wealth by their holders, the 

basic Keynesian conclusions about tax cuts unaccompanied by 

spending reductions also change. For if bonds are not considered

wealth, a tax cut has little effect upon aggregate demand, and
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its effects are felt almost entirely on the supply side. The

logic of this result follows from the fact that the bonds issued 

to finance the increased deficit brought about by the tax cut 

create an equal offsetting future liability. A cut in current 

tax liability, accompanied by a future tax liability of equal

present value and a current bond purchase equal in amount to the 

tax cut leaves financial positions unchanged in the aggregate. 

Since aggregate financial positions have not changed, aggregate 

demand will be little affected, and so interest rates will also 

be little affected through this channel. The primary effect of 

the tax cut is through incentive effects on the supply side. As 

analyzed above, such supply-aide effects can lead under different 

assumptions to either a rise or a fall in interest rates. 

The assumption that government bonds are not wealth similarly 

alters the Keynesian conclusion about the effect of an increase 

in the deficit brought about by an increase in government spending 

without a balancing increase in the level of taxation. However, 

in the case of government purchases there are additional effects, 

since the government demand preempts real output, and that real 

output is not available for private consumption or investment. 

Insofar as that output is no longer used for private capital formation, capital intensity will be lower, and this will tend to 

raise the productivity of each unit of capital and raise real 

interest rates. On the other hand the productivity of capital and 

real interest rates are also affected by the uses made of output 

bought by the government; so depending upon these uses the productivity of private capital can be either enhanced or diminished. 

° Comments on Empirical evidence

The theoretical analysis presented so far indicates that the 

effects of an increase in the deficit upon interest rates are 

ambiguous; a situation of rising deficits can coincide with a 

situation of either rising or falling interest rates. In addition 

to the reasons given so far, deficits cannot be expected unambiguously to be causally related to interest rates, because a 

deficit is a residual obtained by subtracting two items, government expenditures and revenues, which usually have very different 

effects upon the economy. 

The same deficit can arise with many different levels of 

expenditures and revenues, and the economy will behave differently 

when expenditures are large than when they are small even if the 

deficit is the same in either case. Similarly the effect of the 

deficit depends on whether it arises from a tax cut or an expenditure increase. An increased deficit brought about by a tax 

cut targeted toward stimulating investment may lower pre-tax 

real interest rates while the same deficit increase brought about 

by new unproductive government expenditures would probably raise 

the pre-tax real interest rates. Similarly, the same deficit can
- 13 -

arise with the same levels of expenditures and revenues but with 

different compositions of the expenditures and revenues, with 

consequent different effects on the economy and real interest 

rates. Hence for the deficit per se to have an effect on real 

interest rates it would also have to vary systematically with the 

level of revenues and expenditures and their composition. However, 

it is unlikely that such a systematic relationship, if it exists 

at all, has been very strong, so deficits cannot be expected to

be related to interest rates. 

Attempts to discern systematic relationships between deficits 

and interest rates by examining statistical correlations among 

historical data confirm the ambiguity of conclusions arrived at 

through theoretical speculation. Studies of these relationships

strongly indicate that there is no systematic connection between 

high deficits and high interest rates over the cycle. If anything 

the opposite relationship appears to obtain, in which interest 

rates rise in expansionary phases of the cycle when deficits contract, and fall in contractionary phases when deficits tend to 

expand. The historical relationship between deficits and interest rates 

is pictured in Chart 1. 

One could argue that this evidence merely reflects the substitution between public and private demand for real credit in 

consecutive phases of economic cycles, as is depicted in the 

accompanying Chart 2. Consequently, the argument goes, if it 

were not for government deficits (especially during expansionary 

phases) interest rates would have been even lower and the attendant economic expansion stronger. In order to test hypotheses 

like this, and to examine more precisely the relationship between 

deficits and interest rates, it is necessary to control for other 

influences upon interest rates so that the effects of deficits 

can be isolated. Such other influences include the effect of the 

growth rate of money, general business cycle effects, and the 

effects of risk in markets as induced by volatility in money 

growth. Numerous econometric studies have tried to isolate the 

effects of deficits, and they have failed to establish reliable 

evidence that government deficits have a noticeable effect on 

interest rates.

DEFICITS AND EXCHANGE RATES 

The effects of deficits on exchange rates may be even more 

complex than the effect upon interest rates. In a basic Keynesian 

model the exchange rate is implicitly determined by net exports 

which, in turn, essentially depend upon the income propensities 

to import at home and abroad. In such a model, without the 

capital account specified, an increase in the government deficit 

leads to an expansion of aggregate demand. For a given domestic
- 14 -

propensity to import, this worsens the trade balance and sets the 

stage for a depreciation of the domestic currency. But since in 

this model an increase in the deficit also causes the interest 

rate to go up, a higher interest rate is associated with a weaker, 

not a stronger, currency. 

This Keynesian result stands in stark contrast to widely 

held views, especially in financial circles, about the relationship between interest and exchange rates and, by extension, 

between government deficits and exchange rates. These contrasting views are apparently derived from monetarist models of exchange 

rate determination. In a basic monetarist model the exchange

rate is dependent upon the ratio of money supplies of two currencies per unit of output in the corresponding countries. The 

exchange rate is therefore essentially a monetary phenomenon. 

If, however, the money supplies are held constant and in one 

country, fiscal expansion stimulates aggregate demand or incentives induce higher aggregate supply, the money supply per unit 

of output is reduced in this country and its currency would 

appreciate. The exact mechanism which brings about this appreciation can be given alternative interpretations. A reduction of 

the money supply relative to output may be translated into current 

or expected lowering of prices, including the prices of exportables 

and import-competing goods. The drop in prices, by improving 

the country's competitiveness, then should bring about an improvement in the trade balance and the resulting strengthening of the 

currency -- just as in a Keynesian model. Alternatively, expansion of output in conjunction with a non-accommodating monetary 

policy may be interpreted as a liquidity squeeze resulting in 

higher interest rates that would induce capital inflows from 

abroad and make the currency appreciate. 

Thus, the monetarist analysis can lead to a trade (or current 

account) surplus and a capital account surplus. Of course these 

results are incompatible, or at least unsustainable over a longer 

period of time, because the only way a trade (or current account) 

surplus can be financed is by a capital account deficit. Furthermore, monetarist models disregard income effects on trade flows 

which are the focus of Keynesian analysis, as indicated earlier. 

When the analysis of fiscal expansion combines these income 

effects in a basic Keynesian model with the price depressing and 

interest rate boosting effects imbedded in monetarist models, 

the result is ambiguous. While the income effects would tend to 

worsen the trade balance and thus weaken the currency, the price 

effects would tend to improve the trade balance and thus strengthen 

the currency, and the interest rate effects would tend to improve 

the capital account and thus strengthen the currency even further.

The actual outcome of a fiscal expansion would depend on the 

potency of exchange rate responses to these effects. Empirical 

estimates of the relevant parameters are very imprecise and even
- 15 -

the most sophisticated quantitative models of exchange rate 

determination are notoriously unsuccessful in explaining past, 

let alone predicting future, exchange rate movements. 

There is no reliable empirical evidence to support the 

contention that large government budget deficits cause appreciation of the country's currency, at least as far as the dollar

is concerned. Although deficits tend to rise during periods of 

economic contraction and fall during expansion, the real multilateral trade-weighted value of the dollar declined during both 

the contraction of 1974-75 and the expansion of 1976-79, before 

rising over the period 1980-83 during which the economy both 

contracted and expanded. This pattern of exchange rate changes 

occurred despite frequent efforts of governments, including the 

U.S. Government, to counter cyclical exchange rate movements. 

DEFICITS, INFLATION AND THE MIX OF OUTPUTS

Can the deficit affect inflation? The answer is that although 

deficits can be observed to rise while the inflation rate falls,

it is possible that an increase in the deficit can put some temporary upward pressure on the price level even if the deficit is 

not monetized. In other words, although monetary policy is the 

dominant influence on inflation, the deficit (as well as changes 

in inflationary expectations, and exogenous supply shocks) has 

the potential for affecting the price level. 

When taxes are cut and government borrowing increased by an 

equal amount, some of the tax cut will be spent on the new government bonds. According to the earlier detailed analysis, the

total amount of the tax cut will be used to purchase the new 

bonds if the taxpayers/bond buyers assume that the bond interest 

received will be used to pay the future tax required to service the 

government debt, and that the return of the principal of the bond 

will be used to pay the future tax required to retire the bond

In any other case -- unless the debt is monetized, and 

assuming that the tax cut does not take a form which changes 

savings incentives and causes a change in the percentage of income 

saved -- it would appear that some of the tax reduction will be 

saved and some will be spent on private consumption. Relative 

price (incentive) effects aside, because not all of the tax cut 

is saved, the demand for bonds rises by less than does the supply. 

With the growth of money unchanged, the shift in the demand and 

supply of bonds puts upward pressure on real interest rates. 
- 16 -

Thus, real interest rates rise and discourage investment 

demand unless a tax cut is of a type which raises the after-tax 

rate of return to capital or lowers the user cost of capital. 

But higher interest rates also encourage asset holders to shift 

some money balances into bonds (financial assets). Therefore, 

the real interest rate increase does not reduce investment demand 

by as much as the increase in consumption, so total demand rises. 

To the extent that total demand increases relative to the total 

supply of goods and services, (still assumed, for analytical 

simplicity, to be unresponsive to the tax cut), upward pressure 

is exerted on prices. The pressure will stop once prices have 

risen by enough to restrain total demand from exceeding total 

supply. 

The price pressure will be self-terminating if monetary 

policy remains unchanged. Because the higher prices reduce the 

real value of money balances, asset holders shift some of their 

wealth out of bonds (financial assets) and into money. As a 

result, there is a secondary rise in real interest rates which 

discourages investment demand by enough to offset the initial 

increase in consumption demand. 

Thus, in this analysis with no supply-side effects considered, 

a tax reduction accompanied by an equal increase in the deficit 

causes a temporary increase in inflation, a permanent rise in the 

price level and in real interest rates, and a permanent decline 

in investment.

Acceleration of money growth in an attempt to counter the 

upward pressure on real interest rates would prolong and accelerate 

the rate of inflation. But eventually real interest rates would

rise by enough to reduce investment to equal the increase in consumption. Evidence on the extent to which deficits have been 

monetized is mixed, but there are some data that at least suggest 

that in recent U.S. history there has been a positive relationship 

between the percentage increase in the privately held Federal 

debt and the rate of growth of the monetary base. 

If, in contrast, monetary policy maintains a disinflationary 

path for the economy, the growth of money may be reduced to forestall any inflationary pressure from the deficit. In the current 

U.S. experience the reduction in money growth has been more than 

the required offset, thus excessively depressing the demand for 

financial assets and causing higher real interest rates without 

the occurrence of any observable upward pressure on prices. 

The deficit can affect the mix of output, but the process 

may be a complicated one. As is indicated in the foregoing 

analysis of the process by which the deficit can affect inflation, 

in the absence of supply-side effects, the deficit increase will 

discourage investment to the extent that it results in a direct 

increase in current consumption. The adjustment occurs as the
- 17 -

increased deficit causes the supply of bonds (financial assets) 

to exceed the demand, thereby putting upward pressure on real 

interest rates. Higher real interest rates then crowd-out private 

(and state and local government) borrowing in the competition for 

available loanable funds. 

° A digression on crowding out

The term "crowding out" is used loosely in popular discussions 

to convey the notion of a displacement of private investment by 

government borrowing at high interest rates. But this notion is 

misleading and the concept of crowding out is murky. 

Because credit is scarce it is rationed by capital markets, 

and so even if government is totally absent from capital markets, 

some potential borrower is crowded out at any level of interest 

rates. More precisely, producers whose expected rate of return on 

new investment is less than their cost of borrowing to finance 

this investment, or consumers who delay their purchase rather 

than pay the cost of borrowing to finance present consumption, 

will be crowded out. Crowding-out thus refers to the financial 

market process of allocating limited credit to the users able to 

pay the highest prices. To the extent that the scarcity of credit 

is alleviated, for example by an autonomous increase in savings, 

room is made for less profitable investment projects (or less 

desirable consumption expenditures) that would be crowded out if 

the supply of loanable funds were less abundant. 

If the government were just another borrower in the credit 

market, its role would not be materially different from that of, 

say, AT&T, which because of the sheer size of its credit demands 

presumably displaces many small businesses. The unique role of 

the government in crowding out other potential borrowers does 

not, however, have to do so much with the size of its claims on 

the pool of available credit, as it does with (a) the fact that 

the government borrowing is interest rate insensitive, and

(b) the fact that the government borrows to finance predominantly 

activities that do not add to future productive capacity. In 

these two respects the government is indeed different from any 

other borrower. 

The first distinction appears to imply that for a given 

supply schedule of loanable funds, borrowing by the government 

raises the interest rate thereby crowding out some marginal 

borrowers. However, several qualifications deserve mention in 

discussing this process of financial crowding out. First, if for 

instance, increased government borrowing finances a corporate tax 

cut, cash flows internally generated by corporations will increase 

and demand for credit by these corporations will decrease commensurately. Thus, increased borrowing by the government will 

coincide with decreased borrowing by the private sector. Second, 

insofar as the supply of savings expands as the interest rate
- 18 -

rises, the amount of credit foregone by potential private 

borrowers will be smaller than the increase in government borrowing. Third, the concept of financial crowding out does not contain any normative implications; that is, for a given level of 

government spending no general assertion can be made that financial crowding out is more deleterious to the economy than alternative methods of financing this level of government expenditures. 

The implications of the second distinction between the 

government and other borrowers are more clear cut and also more 

important for proper evaluation of the consequences of government 

spending on credit markets. Since government spending is, from

the standpoint of generating future growth, mainly nonproductive, 

it preempts some resources which otherwise would have been used 

for investment purposes. Even though the lower rate of investment 

results from interest rate adjustments in the bond market, this 

result is not essentially a financial phenomenon. The reduction 

in investment reflects the resource allocation required when 

increased government expenditure demands compete with private 

investment and private consumption for limited amounts of labor, 

capital and other productive inputs. Preemption of these productive factors by the government is sometimes labeled real, as 

distinct from financial, crowding out and its effect on the 

economy in the medium term is the same independently of whether 

this preemption is financed by borrowing or by taxes. This 

conclusion may be altered, however, when incentive effects are 

recognized. 

INCENTIVE EFFECTS

Incentive effects -- that is, the increase in the supply of 

productive factors caused by improved incentives resulting from 

cuts in marginal tax rates -- are most important when the tax

cuts are permanent rather than temporary. Permanent tax cuts 

provide permanent incentives to alter the supply of labor and 

capital. A temporary tax cut provides only the incentive to alter 

the timing of that supply; if more is offered now, less will be 

offered later when the temporary tax cut is removed. A tax cut 

financed by government borrowing may be viewed as temporary to the 

extent that the borrower expects that tax rates will be raised in 

order to retire the debt issued to finance the tax cut in the 

first place. This is the reason why a tax cut accompanied by a 

reduction in government spending is more likely to be viewed as 

permanent than a tax cut not matched by a reduction in government 

outlays. 

To the extent that a tax cut enhances economic growth, 

government borrowing to finance the tax cut will be less likely 

to crowd out private investment. This is because more growth 

means more saving, that is, more available loanable funds to meet
- 19 -

the new supply of bonds. In this case, there would be less upward 

pressure on real interest rates and on prices, resulting in more 

private investment and a different consumption pattern than would 

occur without a tax cut and the corresponding increase in government borrowing. 

POTENTIAL GROWTH AND THE STRUCTURAL DEFICIT

The extent to which a tax cut enhances potential economic 

growth has important implications for estimating and interpreting 

the effects of a deficit increase associated with a tax cut. 

Potential output growth is a concept used to characterize the 

performance of an economy that is operating on its long-run output 

trend with all available resources fully employed in their best 

uses. The concept is rather subjective because it is defined with 

terms such as available, fully and best. Furthermore, it is not 

defined in terms of relevant alternative dimensions of policy --

e.g., a disinflation path or a certain income distribution 

pattern, etc. -- taken as a first priority of economic policy. 

However, the concept of potential economic growth is estimated 

for some specified time period assumed to be policy relevant, as 

the sum of the growth rates of the labor force, productivity per

worker, and annual hours of work per worker. Given this standard 

of potential economic growth, an estimate of the Federal deficit 

can be separated into a cyclical component and a noncyclical or 

structural component. The cyclical component of a given deficit 

is the portion that exists because the economy is operating at

a level of activity below potential -- the assumed high or full 

employment level. The difference between the estimated total 

deficit and the estimated cyclical component is defined as the 

structural deficit. 

By definition, the faster is the projected rate of actual

economic growth (given the assumed potential rate of growth, 

that is, the closer to the prespecified level of full employment 

the economy is projected to be, the smaller is the cyclical 

component of the deficit and the larger the structural component. 

Thus, given an estimate of the total deficit, if the economy is 

projected to be at full employment (however defined) in 1988, all 

of the estimated deficit would be labeled, by definition, as 

structural. 

For this reason it has been said that economic growth cannot 

close the structural deficit. This statement is tautologically 

true but misleading because it is not fully informative. A more 

complete statement would note that the assumed potential rate of 

growth is rather arbitrary, and a higher potential rate of growth 

generally would be consistent with a smaller total deficit and 

therefore at full employment with a smaller or zero structural 

deficit. 
- 20 -

Some commentators suggest that the long-run trend (or the 

trend over some particular time period) of the structural deficit 

should average out to be zero. But this prescription would appear

to depend in part on the extent to which government spending is 

used for such purposes as: to pay interest on that part of the 

nominal increase in the Federal debt that, during a period of 

expected inflation compensates debt holders for loss in the real 

value of the principal; to make loans to the private sector; and 

to purchase items that are appropriately financed by borrowing --

for example, highways, buildings, research, development and education come to mind. 

Chart 3 illustrates the ambiguity inherent in definitions of 

potential GNP (from which the notion of structural deficit is 

derived) as well as the dangers of treating the structural deficit 

as the main policy goal or even as an indicator of successful 

policy. For illustrative purposes, two alternative growth paths 

of potential real GNP are drawn. The first alternative corresponds 

to a potential GNP associated with the full employment unemployment rate of 5.1 percent, the second alternative to 7.0 percent. 

Hence, in 1982 the GNP gap, that is the difference between potential GNP and estimated actual GNP, is larger for the first definition of potential GNP than it is for the second. Under the 

first alternative it is assumed that a tax increase, prescribed

to reduce the structural deficit, holds the rate of growth of 

potential GNP to 2.5 percent per year. Under the second alternative, in the absence of such a tax increase it is assumed that 

the growth rate of potential GNP is still a modest 3.7 percent. 

Actual output grows 4.1 percent per year under the first alternative and 4.4 percent under the second. 

By 1988, under the first alternative (lower potential growth) 

the GNP gap is closed (actual growth has exceeded potential during 

the period) and, by definition, the cyclical component of the

deficit is eliminated. Under the second alternative (higher 

potential growth) the GNP gap still equals 1.0 percent of GNP 

(actual growth has exceeded potential, but not enough to close 

the gap by 1988) and the cyclical component of the budget deficit 

is not eliminated. Furthermore, again by the very nature of the 

constraints employed, in 1988, the structural deficit is larger 

under the first alternative, associated with a lower rate of 

potential growth and a lower rate of full employment unemployment than under the second one, associated with a higher rate of 

potential growth and a higher rate of full employment unemployment. 

The latter outcome would appear to be preferable to the former

one because it results in a faster actual growth and a higher 

actual level of output by the end of the period. 

An inference can legitimately be drawn from this example 

that, insofar as tax increases have a recognized depressing effect 

on economic growth while the effects of deficits on growth are

not necessarily depressing, at least not under all circumstances, 

it would be prudent, as a matter of policy, to be cautious -- even
- 21 -

to err on the side of restraint -- in trying to eliminate structural 

deficits by raising taxes. 

The effects of deficits on economic growth are difficult to 

identify, isolate, and measure. Indeed, as indicated above,

there is some controversy about the proper way to measure the 

actual deficit. And certainly the structural deficit is a controversial and arbitrary concept which can be estimated only in 

a subjective and imprecise way. 

But even leaving such difficulties aside, there remains the 

forbidding task of attempting to draw conclusions about the 

economic effects of structural deficits. These effects would 

depend on a great variety of factors, among which the level and 

composition of government spending and the structure of the tax 

system would play a particularly important role in determining 

the path of economic growth, while the course of monetary policy 

would play a crucial role in determining the level of prices, 

nominal interest rates and exchange rates. 

A SHORT NOTE ON THE LONG RUN

The connection between government deficits and prices (including interest rates and exchange rates) in the long run is analytically very interesting, empirically intractable and extremely 

important from the standpoint of formulating appropriate policy 

responses. It is in the long run that rational economic 

agents will, by definition, have made the necessary adjustments 

to new economic circumstances. 

In the present discussion, long-term changes in habits 

affecting the supply of labor, the supply of savings and the 

attitudes toward enterpreneurial risk are particularly important 

because these factors will have a decisive influence on prices, 

real wages, interest and exchange rates. While it is beyond 

dispute that some tax regimes are bound to elicit a larger supply 

of labor and savings and be more encouraging toward entrepreneurship than others, magnitudes of these responses cannot be known 

in advance. The very notion of a different environment in the 

long run logically prevents using estimates of relevant parameters 

based on historical data, that is, those pertaining to an old 

environment. Therefore, one can only speculate on what might

be the effect of continuing deficits (and therefore a growing 

Federal debt) on prices of financial assets and, more fundamentally, on economic growth. 

In brief, for some combination of elasticities of supply of 

labor and private savings, marginal output-to-labor and output-tocapital ratios, a given structure of marginal taxes, and a composition of government expenditures (in terms of growth-enhancing
- 22 -

and growth-retarding categories), there will be some sustainable 

level of secular budget deficits (and the implied Federal debt) 

relative to GNP. It is not possible to state a priori what that 

level might be but it need not necessarily be zero. The sustainable deficit-to-GNP ratio (and implied Federal debt-to-GNP 

ratio) would be higher the higher are

-- responsiveness of supply of labor and savings to net 

rates of return,

-- marginal output-to-labor and output-to-capital ratios,

-- average marginal taxes (at unchanged elasticities of 

supply of labor and capital),

-- the proportion of productive expenditures (investments) 

by the government in its total spending.

The question of what a tolerable deficit-to-GNP ratio (and 

the implied Federal debt-to-GNP ratio) might be cannot be answered 

without having some idea about the magnitudes of parameters specified above. Estimation of these parameters by means of traditional 

econometric methods does not produce satisfactory results. However, pertinent simulations (performed by IMF economists among 

others) which are based on a range of possible values of relevant 

parameters indicate that the supply effect of budget deficits 

attributable to tax rate cuts, while rather weak in the short 

run, dominates the demand effect in the long run for a variety

of plausible combinations of parameters in question. What can 

be deduced, therefore, is that the secular trend of deficits, if 

kept at a sustainable level (that is, not resulting in an explosive 

growth of debt-to-GNP ratio) may be more conducive to economic 

growth than if the corresponding amount of funds were raised by 

taxing the productive factors in the economy. 

Finally, even if one were to accept the proposition that a 

continuing high deficit-to-GNP ratio(and the implied Federal 

debt-to-GNP ratio) causes high interest rates, one could not conclude that these high interest rates will unavoidably result in 

slow economic growth. If tax cuts and tax reforms geared toward 

creating economic incentives, rather than increases in non-productive government spending, are the prime reason for deficits, 

high real interest rates may have no discernible effects on the 

rate of economic growth. In fact, evidence abounds that during 

periods of economic buoyancy and optimistic expectations, as, for

instance, in the 1920s and 1960s, high investment levels and 

concomitant high growth rates may prevail for long stretches of 

time despite high (real) interest rates and, vice-versa, low 

(real) interest rates prevalent, for instance in the 1930s and 

1970s, by no means guarantee high investment levels or robust 

growth. 
- 23 -

CONCLUSIONS

The main purpose of this study was to review the issue 

concerning the effects of government deficit spending on interest 

rates and, to some extent, on exchange rates. Frequently encountered assertions about the causal links between deficits and 

prices of financial assets were critically examined and evaluated. 

Contrary to some widely publicized opinions, these effects 

of government deficits are by no means unambiguous. The outcome 

depends, among other things, on the assumption made about the 

saving behavior of the private sector. When taxes are cut and 

government borrowing increased by an equal amount, some (perhaps 

all) of the tax cut will be spent on new government bonds. 

The total amount of the tax cut will be used to purchase the 

new bonds if the taxpayer perceives that future taxes will be 

required to service the government debt and retire the bonds.

In this case, aside from incentive and distributional effects, 

there should be no difference between higher deficit spending 

and spending fully financed by additional taxes -- there is no 

impact on the interest rate whether government spending is 

financed by taxes or borrowing. 

The extreme opposite assumption is that there is no substitution whatsoever between taxes and borrowing by the government; 

extra after-tax personal income is devoted entirely to increased 

consumption, none is saved. Thus, no increase in private saving 

accompanies the additional government borrowing. With no increase 

in the supply of loanable funds, the additional demand for loanable 

funds inevitably results in upward pressure on interest rates. 

Other facts that exert a crucial influence on the outcome are 

the extent to which: deficits are caused by spending increases 

or tax cuts; financing is accomplished by monetization of the

debt or by sale of government debt to the public; the tax cut 

reduces marginal tax rates thus improving incentives to supply 

productive labor and capital; the outlays financed by the deficits 

change the composition of government spending. The results are 

also influenced by the magnitudes of the private sector's various 

responses to the specifics of the policy changes -- responses 

which, for instance, depend on the openness of a country's capital 

markets to foreign investors, public expectations (about inflation 

and interest rates, for example) generated by a prospect of continuing deficits, and a host of institutional arrangements determining the adaptability of labor, product and asset markets to 

changing economic conditions. 

In examining these relationships, the paper shows that many 

widely-advanced conclusions about the macroeconomic effects of 

deficits are not universally valid; as indicated above, they 

depend crucially instead, on the time horizon of the analysis,
- 24 -

the institutional and behavioral assumptions underlying the 

analytical model used, the accompanying circumstances and policies 

postulated and the size of various economic parameters estimated 

or assumed. Also, it is pointed out that there is no conclusive 

empirical evidence to support firmly the contending analyses. If 

anything, the existing empirical evidence points toward no systematic relationship between government budget deficits and interest 

rates or exchange rates. 



PART II

THE EFFECT OF FEDERAL DEFICITS ON INTEREST RATES:

A SURVEY OF THE LITERATURE
PART II

THE EFFECT OF FEDERAL DEFICITS ON INTEREST RATES:

A SURVEY OF THE LITERATURE

INTRODUCTION

There is much current discussion about the potential 

disadvantages of the large projected deficits. These perceived 

risks include, among others, interest rate increases that cause 

short-run reduction in aggregate demand and longer-run reduction 

in the rate of capital accumulation and economic growth, Federal 

interest payments that grow to require ever more Federal borrowing 

to meet them, and the expectation that the increased pressure of 

an ever growing Federal debt would lead the Federal Reserve to 

monetize the deficit and thus re-ignite inflation. 

The discussion of the potentially harmful interest rate 

effects lodged in the large deficits is motivated in part by a 

lack of consensus as to whether an increase in taxes would reduce 

the emerging risks. This disagreement reflects the fact that 

neither theoretical nor empirical analysis provides a clear-cut 

guide for decisions about either the urgency of reducing the 

deficits or the advisability of raising taxes to do so. 

The purpose of these bibliographic notes is to indicate some principal 

sources in mainstream macroeconomic analysis of the 

issue. The notes are organized to present the most general findings first, and then to proceed with more specific and technical 

considerations. After mentioning some recently published surveys 

of the debate about the relationship between deficits and interest 

rates, the paper proceeds to consider measurement of the real 

deficit and public debt and the real interest rate. Next is a 

concise review of some econometric tests of the effect of Federal 

deficits and debt on interest rates. Finally, some major unsettled 

issues in the macroeconomic theory underlying the deficit/interest 

rate analysis are discussed briefly. The conclusion from the 

literature reviewed here is that the deficit/interest rate relationship remains an unsettled question. 

SOME RECENT SURVEYS OF THE DEBATE

Several recent publications survey major issues in the discussion of the effect of deficits on interest rates. An accurate 

characterization of the state of the debate can be found in a

paper by Rudolph Penner (1982) in which he reviews the literature 

on macroeconomic policy and domestic saving, and concludes that 

economic research on the issue is in a primitive state, precise 

answers are far beyond our grasp, but nevertheless the projected 

ratio of deficits to GNP is so high that it poses a risk to 

economic growth. Recognizing that there is no consensus on such 

issues as: the effect of changing levels of Federal deficits, 

the effect of changing after-tax rates of return on aggregate
- 29 -

savings, whether monetary policy should be loosened, or whether 

growth in Federal spending on defense, retirement, and health can 

be cut, he recommends a tax increase which emphasizes base 

broadening measures (to avoid adverse supply-side consequences) 

and would have its major effect after 1985 (to avoid adverse 

short-run demand-side consequences). 

Commenting on Penner's paper, James Tobin (1982) casts doubt 

on assertions of near-term adverse effects of the current and 

projected deficits and on the current benefits to be achieved by 

current actions to reduce future deficits. He notes that the 

main impact of the 1982 TEFRA tax increase was to reduce business 

saving and investments by repealing about half of the concessions 

to capital income enacted in the 1981 ERDA tax cut. Tobin 

expresses concern that future deficits during periods of prosperity will combine with high interest rates to raise the ratio of 

the Federal debt to GNP, but, he says that hysteria appears to 

be premature and overdone, and offers calculations that suggest 

that the debt-to-GNP ratio in the next 10 years would return to 

its level of the 1950s, about 50 percent. He revises downward 

that estimate to about 32 percent in a subsequent, more detailed 

analysis for the Conference Board (1983). Tobin notes, however, 

that if the defense build-up is not simply a bulge, [more] taxes 

will be required to pay for it. Tobin emphasizes that monetary 

policy is the key to recovery, that tightening fiscal policy 

would help provide a policy mix more favorable to capital formation, but that the effort would be wasted "unless the Fed engineers low enough real interest rates to absorb in investment the 

resources released by government, its taxpayers and its transferees -- plus a big fraction of the resources made idle by the 

recession." He says that macroeconomic policy is immobilized by 

an irrational fear that a temporary burst of money supply growth 

would be entirely dissipated in renewed inflation and have no 

real effects. 

Four recent volumes which contain collections of current

research bearing on the subject of the effects of deficits on

interest rates are: The Boston Federal Reserve Bank 1983 conference

volume, The Economics of Large Government Deficits (to be published

in 1984), the Washington University (St. Louis) 1982 conference 

volume, The Economic Consequences of Government Deficits, the 

Conference Board report of the December 1982 conference, Toward a 

Restructuring of Federal Budgeting (1983), and The Deficit Puzzle,

a special issue of the Economic Review, Federal Reserve Bank of 

Atlanta, August 1984. References to some of the papers in these 

volumes appear below. 

As indicated above, empirical research on the deficit/interest 

rate relationship is inconclusive. In part, this is because it

is difficult to construct suitable measures for the key concepts. 
- 30 -

MEASURING THE REAL DEFICIT AND DEBT

The relationship between the deficit and interest rates, 

investment, and growth, is analyzed best in real rather than

nominal terms. Empirical studies of the effect of the real Federal deficit on the real interest rate require a correct measure 

of the real deficit (the nominal deficit less some portion of 

interest payments on the Federal debt). Measurement issues 

include the difference between the NIA and unified budget concepts, 

the advisability of relating the absolute size of the deficit to

a measure of the size of the economy (such as GNP or population), 

and adjustments for cyclical effects. In addition, the appropriate valuation of the real market (rather than par value of the 

Federal debt and therefore of the real deficit, the annual flow 

that reflects the change in the stock of Federal debt) is crucial 

to the analysis and empirical estimate of the macroeconomic 

effects of the financing of government expenditures. 

Phillip Cagan (1981) notes that it is customary to put the 

nominal deficit into real terms by deducting the product of the 

amount of publicly held Federal debt multiplied by the inflation 

rate (per the fixed weight GNP deflator). To the extent that 

interest payments on the debt include an inflation premium equal 

to the inflation adjustment (or depreciation) of the debt, and to 

the extent that debt holders regard these additional interest 

payments as a return of principal (rather than income to be consumed), the reinvestment of the additional interest will finance, 

without "crowding-out," an equal amount of deficit. 

But, Cagan points out that the additional interest due to 

inflation (the inflation premium) may differ from the depreciation 

in the value of the debt. The difference arises when expected 

inflation is an inaccurate forecast of actual inflation. The 

inflation premium reflects the additional interest required to 

compensate for the inflation rate expected when the debt was 

issued, rather than the actual inflation rate that occurs when 

the depreciation in real value of the debt is calculated. If 

expected inflation has been less than actual, the additional 

interest (premium) will be less than the depreciation of the debt. 

Thus, Cagan concludes that a proper measure of the deficit 

would not exclude the entire decline in the real value of the 

debt, rather only the extra interest viewed by lenders as repayment 

of principal (and thus available to finance new Federal deficit 

without absorbing new saving) should be excluded. In other words, 

the deduction from the interest cost of servicing the debt should 

equal the amount of the so-called Fisher effect (i.e., the 

inflation premium in nominal interest rates, reflecting inflation 

expected over the life of the debt instrument). 
- 31 -

Cagan also notes that uncompensated declines in the real 

value of the debt result in capital losses to the private holders 

of the debt. These losses are a source of a further effect of 

inflation on debt financing, to the extent that the losers gradually attempt to save more to replace the loss to their financial 

capital stock. Cagan notes that estimates of this wealth effect 

range between 2-1/2 to 5 percent per year of the change in wealth; 

an uncompensated decline in the real value of the debt would add 

to the annual saving flow about 2-1/2 to 5 percent of the decline. 

He estimates that from the mid-1960s through FY 1982, the uncompensated decline was about $275 billion in 1981 dollars. Thus, 

according to these calculations, this effect adds about $7 billion to $14 billion per year to the flow of saving (and does

not change much year-to-year because it reflects accumulated 

capital loss on the debt). 

William Fellner (1984) estimates that during the period 

1954-1982, total private net worth underwent a positive real

revaluation (in excess of the PCE deflator) -- measured as the 

algebraic sum of overlapping three-year spans -- of about $3.5 

trillion. Then, based on a regression estimate, he finds that consumption 

would rise -- or, equivalently, saving would fall --

by about 2 to 3 percent of the revaluation ($70 to $90 billion). 

Since he estimates personal saving was about $1.5 trillion over 

the period (personal income was about $22 trillion), the revaluation would result in a 5 to 6 percent reduction in personal 

saving. 

In an attempt to focus on the revaluation of financial 

assets, Fellner notes that the revaluation estimate should be 

taken as a "package," and that only a shaky estimate can be made

for a decomposition of the total revaluation. However, he estimates that the real revaluation of net fixed dollar positions

and corporate equities is a negative $0.4 trillion and the positive 

effect on savings is about $20 billion. This estimate is rather 

modest in size. But Fellner's revaluation takes the PCE deflator 

as the basing point (revaluation does not begin until after the 

change in the PCE deflator is applied). And because the government debt is taken at par value his revaluation estimate includes 

no adjustment to government debt. 

To the extent that interest rates change, the par value of 

debt is an inaccurate approximation to its market value. John 

Seater (1981) has constructed several series on the year-end 

market value of outstanding government debt. His series are 

exact measures of market value in that they are based on actual 

price quotes for each specific issue. The series include data on 

bonds, notes, certificates of indebtedness, and bills, for the 

period 1919 to 1975. He compares his results with existing data 

series constructed by other methods and shows that his are a 

considerable improvement. 
- 32 -

W. Michael Cox and Eric Hirschhorn (1983) extended Seater's 

data by calculating the market value of outstanding Federal debt 

monthly from 1942-1980. They provide separate series for Treasury 

bills, bonds, certificates of indebtedness, notes, and total 

Treasury debt, along with estimates of privately held Treasury 

debt and gross Federal debt. 

James Butkiewicz (1983) notes that the data series constructed 

by Seater and by Cox and Hirschhorn are costly to calculate. 

Therefore, he developed an alternative technique to estimate the

market value of outstanding Federal debt. His approach is based 

on the assumption that all debt may be aggregated into a single 

issue of average maturity and average coupon interest rate. His 

method is less costly than direct calculation, with only a marginal 

reduction in accuracy. 

Robert Eisner and Paul Pieper (1984), following the three 

studies just mentioned, and others by Horigan and Protopapadakis 

(1982), and the Economic Report (1982), revalue the Federal debt

to adjust for the effect of inflation and for differences between 

par and market values. Of course, these valuations in the stock 

of debt imply revaluations in the annual flow of deficit --

revaluations from what would be observed as either the unified 

budget or the NIPA budget deficit estimate. 

The Eisner and Pieper revaluations indicate that the real 

(constant dollar) market value of net Federal debt (net Federal 

debt equals gross debt minus financial assets) has fallen by half 

from 1946 to 1980, while budget deficits have occurred repeatedly. 

Eisner and Pieper also calculate the real market value for other 

liabilities of the government and its assets and conclude that 

Federal net worth has risen during the period. 

They incorporate their inflation and par-to-market (i.e., 

interest-rate-related) gains and losses into the calculation of 

the high employment budget noting that without these adjustments 

the data would confuse nominal flows with changes in real stocks. 

Since the revaluations apply to the net debt, they are less than 

those for the gross debt. 

In the opinion of Eisner and Pieper, a deficit that does not 

increase the net debt of the government does not increase the net 

income or the net wealth of the private sector and therefore does 

not have, per se, an expansionary effect on aggregate demand. 

They find that after their adjustments the recent official estimates of high employment deficits become surpluses. Thus, they 

conclude that fiscal policy on a full employment basis during 

the 1981-1982 recession was quite tight rather than quite loose, 

as suggested by the published official data (both unified and 

NIPA). 
- 33 -

As will be indicated below, although some econometric 

estimates of the effect of the deficit on the interest rate 

refer to the real deficit, it appears that the change in the 

Federal debt is adjusted only for inflation and not for the 

change from par to market value. The use of market value would 

probably introduce simultaneous equation bias into a regression 

equation used to estimate the real interest rate as a function 

of the deficit. However, it would appear that this problem can 

be solved by deriving a reduced form equation from a system

where the interest rate is a function of the deficit, and a second 

equation where the deficit is a function of the interest rate. 

Research to improve the estimates of an appropriate valuation 

of the Federal debt and the deficit continues. A major area of 

open inquiry is the estimation of expected inflation. This

subject is also closely related to the measurement of the real

interest rate. 

MEASURING THE REAL INTEREST RATE

To estimate the relationship between the real deficit on 

real interest rates, it is necessary to have a data series for 

each variable. The real interest rate (r) is an unobservable 

concept defined as the difference between the nominal interest 

rate (i -- which is observable) and the expected rate of inflation (pe -- which is unobservable) over the period of the loan. 

The basic reference on this topic is Fisher (1930), and further

discussion is in Mundell (1963), Tobin (1965), Sargent (1973), 

Joint Economic Committee (1981), Santoni and Stone (1981), and 

Wood (1981). 

Since expected inflation cannot be observed, it must be 

estimated in order to calculate the real interest rate. One way 

to do this is to assume that expectations about the future rate

of inflation are formed on the basis of past inflation experience,

such as observed (historical) inflation rates. This approach comprises a variety of hypotheses including the so-called extrapolative, the adaptive, and the distributed lag, which in some cases 

involves a form of learning or error correction in the formation 

of expectations. Turnovsky (1970) and Tanzi (1980), and the 

references cited there will acquaint readers with the large 

literature on this subject. Papers containing work using distributed lag models include Yohe and Karnosky (1969), and Feldstein 

and Chamberlain (1973), in addition to those noted below in the 

section on econometric tests of the effect of deficits on interest 

rates. 

Another approach to modeling the formation of inflation 

expectations is to attempt to implement empirically the concept 

of rational expectations. The concept assumes that individuals 

use all of the information available, including information about
- 34 -

economic policy variables such as money growth, and do not make 

systematic mistakes in their expectations. Thus, as regards 

inflation, most versions of this theory would imply that, apart 

from a pure random error which is serially uncorrelated, people's 

estimates of inflation are correct. Mishkin (1981) and Plosser 

(1983) are examples of studies that employ the rational expectations hypothesis. For more on rational expectations in general, 

see Muth (1961), Shiller (1978), and other references listed 

below in the section on rational expectations. 

Some recent studies concerning the real interest rate,

including Wilcox (1983), Peek (1982), Reza (1983) and others use 

Livingston survey data. These data are gathered in surveys of 

people's actual expectations about inflation. The data and their 

use are discussed in papers by Gibson (1972), Lahiri (1976), 

Mullineaux (1980) and Tanzi (1980). 

Assuming a satisfactory measure of the expected inflation 

rate, some investigators have questioned the Fisher hypothesis 

that i responds by an amount equal to the change in pe, that is, 

that the real rate is determined by real factors and is not 

affected by inflation. Thus, a growing number of studies consider 

the reasons why and the extent to which the real rate varies over 

time (aside from random fluctuations). Sources on this topic 

include, in addition to the papers mentioned earlier in this 

section, the basic study by Fama (1975), Carlson (1977), Nelson 

and Schwert (1977), and very recent studies by Peek (1982), 

Summers (1983), Makin (1983) and Wilcox (1983). 

Some empirical estimates of the relationship between i and

pe indicate that although they move in the same direction, the 

change in i may be larger or smaller than the change in pe. 

Given the Fisher hypothesis, such an outcome might arise from any 

one of several sources. The result can be interpreted as evidence 

of irrational behavior by investors, or of statistical instability 

of the coefficients estimated from an inadequate specification of 

the relationship between i and pe, or that the data series on pe

measures factors other than the expected inflation rate. Several 

examples of such factors have been examined. One is the Mundell 

(Tobin/Sargent) real balances effect which implies that i responds 

by less than the change in pe. Mundell's result occurs because 

inflation reduces the value of real money balances, and hence 

wealth, thus increasing saving and reducing the real interest 

rate. A second factor is the income tax effect, which would 

cause i to respond by more than the change in pe, because a

tax must be paid on the inflation induced increase in interest 

income. Supply shocks constitute a third factor. 

Makin (1983) and Peek (1982) discuss, cite literature about, 

and offer empirical evidence confirming the Mundell effect. The 

Peek paper provides the same information regarding the tax effect. 

Makin says his analysis (which controls for the effects upon the 

expected real interest rate that result from money surprises,
- 35 -

anticipated inflation, inflation uncertainty, and the impact of 

taxes) suggests that market interest rates reflect an efficient 

inflationary premium, and notes that this result is largely 

contrary to recent findings by Summers (1983). Also he doubts 

that an "uncertainty premium" elevates market interest rates. 

Over the full sample period he found the premium to be negative, 

reflecting negative pressure on market rates from depressed real 

investment that outweighs the possible positive impact from 

depressed real saving. 

The latter conclusion may be compared with the Mascaro and 

Meltzer (1983) analyses that increased variability of unanticipated 

money growth raises demands for debt and money and reduces the

demand for real capital. In contrast to Makin, they find that 

interest rates on both short- and long-term debt rise by a risk 

premium. They estimate that, on average, over the period 1980 to 

1981, the risk premium was 3.3 percent in short-term and 1.3 percent in long-term rates, and that the size of the risk premium 

rose after the October 1979 change in Federal Reserve procedures. 

Wilcox, in addition to recognizing the Mundell and tax 

effects, tests the hypothesis that supply shocks (e.g., an oil 

price increase) have an effect on the nominal interest rate over 

and above the effect of inflation expectations. He finds that 

real interest rates fell in the latter 1970s in response to a 

reduction in the supply of energy, because as input prices rose, 

the profitability of, and demand for, capital fell, and the 

decline of investment and the lowered growth rate of the capital 

stock dragged down the real rate of interest. His estimates

suggest that by 1978 supply forces had pulled real pre-tax interest rates down 1.7 percentage points from their 1972 level. The 

shock probably reduces net real after-tax return to some existing 

capital, while new fuel efficient capital would have a higher 

return. However, the output contraction effect of the increase in 

the relative price of oil is a real loss in income and wealth 

which reduces the desired capital stock and thus depresses the 

demand for investment, and therefore tends to reduce real interest 

rates. 

Thus, Wilcox's model would predict that expansionary fiscal 

policy, coupled with a reduction in the long-run money growth 

rate that depressed the expected inflation rate, would raise real 

after-tax interest rates (in the short run, lower money growth 

would raise real interest rates even further). Increases in the 

supply of energy would likewise tend to raise the real rate. 

Wilcox's hypothesis refers to permanent real supply shocks 

that operate in the longer run. He notes that in the short run, 

with imperfectly flexible nominal wages, supply shocks (e.g.,

material price increase) raise output price -- i.e., the aggregate 

supply schedule shifts up and to the left -- and (other factors
- 36 -

considered unchanged) this lowers real cash balances, increasing 

the demand for money, thereby temporarily raising real interest

rates and lowering investment and output. But in the longer run, 

permanent real supply shocks reduce the return to and demand for 

capital (and labor), and thus drive down real and nominal interest 

rates (ceteris paribus). Wilcox recognizes that real rates may 

fluctuate with the business cycle -- e.g., an upward shift in the 

labor supply function (withdrawal of labor) caused by misperceptions would have the same effect as a supply shock (driving down 

the real rate of return to capital). 

As noted above, the Fisher hypothesis is that the real interest rate is not affected by inflation, rather, it is ultimately 

determined by the real factors that are the source of the marginal

productivity of real capital. Neoclassical macroeconomic growth 

and capital theory, and also microeconomic general equilibrium 

theory, analyze the relationship between the real interest rate 

and the marginal productivity of real capital. Good sources for 

macroeconomic growth theory are Solow (1956) and Burmeister and 

Dobell (1970). References for microeconomic theory are Malinvaud 

(1972) and Samuelson (1947). 

Investigations into the validity of the Fisher hypothesis 

are motivated in part by the conviction that the level of the 

real interest rate rather than the nominal rate is directly 

related to the rate of investment. In general, holding constant 

the rate of innovation or technological change, a higher real

interest rate is associated with less investment and lower capital

intensity. Hence, other things being equal, to the extent that

larger deficits raise real interest rates, they also depress

investment. 

ECONOMETRIC TESTS OF THE EFFECT OF DEFICITS ON INTEREST RATES

Econometric tests are a means of analyzing data in an attempt 

to shed light on the validity of a theoretical insight about economic events. These tests are an essential part of a scientific 

approach wherein questions are confronted with data, and they can 

be especially useful when theoretical analysis provides only 

ambiguous results. However, such tests cannot prove that a specified action causes a certain result. Rather, they provide quantitative estimates (statistically significant within certain 

confidence limits) of the extent to which variation in one 

variable is associated with variation in other variables. These 

probability-based estimates of the strength of such a relationship 

are the basis for a decision to accept or reject the theoretical 

insight about the way in which the world works. 

A number of empirical studies bearing on the relationship 

between real deficits and real interest rates have appeared in the 

last dozen or so years, and the flavor of the debate is conveyed

by summarizing a sample of this literature. Comparison of the
- 37 -

results of these studies is difficult because of a number of 

differences including: the time periods examined; the theoretical 

assumptions; the statistical/econometric methods; the variables 

employed in the analysis; and the data used to measure the 

variables. However, a reasonable conclusion from these studies 

is that there is no consensus regarding the relationship between 

real interest rates and deficits. 

In an article that recently has been subject to reconsideration, Feldstein and Eckstein (1970) attempt to isolate and 

estimate the economic forces that explain the long-term interest 

rate. Their analysis, which combines Keynesian liquidity preference/portfolio balance theory with Fisher's model of the role of 

anticipated inflation, identifies four types of variables --

liquidity, inflation expectations, privately held government 

debt, and short-run expectations about interest rate changes --

as important determinants of long-term interest rates (on seasoned 

corporate Aaa bonds with about 25 years to maturity). 

They conclude that throughout the entire period from 1954:I

to 1969:II the decline in the real per capita publicly held

Federal debt (i.e., the relatively slow growth of the nominal

debt) put downward pressure on interest rates; but that the

Federal deficit (measured by the change in the public debt) is 

not significant in explaining interest rates. However, it is 

important to note that the Feldstein-Eckstein estimate of the 

relationship between the Federal debt and the real interest rate 

is weak in that it is of only marginal statistical significance 

and therefore is not robust enough to endure data revisions. 

They also estimate that nominal rates responded on approximately 

a one-for-one basis with expected inflation, and that the shortrun interest expectation effect was relatively small. 

More recently, Sinai and Rathjens (1983), in an approach 

similar to Feldstein-Eckstein, examined quarterly data for the 

period 1960:I to 1982:III and concluded that their attempt to 

link the per capita deficit -- measured by current changes in the 

publicly held Federal debt -- over their sample period was not 

successful. 

However, they estimated that between November 1979 and 

October 1982, a $1 increase in the projected real per capita 

deficit (the average NIPA deficits for eight quarters into the 

future) was associated with a 0.67 basis point (6.7 percentage 

points per $1,000 of real per capita deficit) increase in the 

long-term corporate bond rate. (A $200 billion nominal deficit 

deflated by the GNP deflator is about $95 billion in 1972 dollars, 

about $410 per person, which in their estimate would increase the 

interest rate by about 2.7 percentage points.)
- 38 -

They note that this result does not apply to the earlier 

period of their data. Thus, their conclusion, that changes in 

future budget deficits have a significant impact now on long-term 

interest rates, is based on a single episode and therefore deserves 

equivocation. The fact that the deficit variable "works" only

for the last 3 of the 22 years in the sample period indicates 

that the relationship is not strong enough to counter the "noise" 

during the period from 1960 to 1979. In contrast, the variable 

representing relative volatility of the bond and stock markets 

(the standard deviation of interest rates?) did "work" for the 

entire sample period, indicating that this volatility variable 

has a stronger relationship with the real interest rate than does 

the deficit. 

The strength of the volatility relationship suggests a line 

of investigation worth pursuing. The risk factor, represented by 

the volatility variable, portrays heightened fluctuation (and 

uncertainty about it and reduced ability to predict it) which 

could be reflected in increased variance in the error term of the 

estimating equation. To the extent this characteristic, heteroskedasticity, is present, the statistical tests of significance 

are adulterated. Thus, it might be advisable to see whether the 

results are robust enough to survive an adjustment for this 

characteristic. 

Also, the econometric estimates indicate enough serial correlation to warrant the reporting of their results after autocorrelation correction, but this was not done. And, their estimate 

indicates that nominal interest rates rise only enough to cover 

about half the expected future inflation, which in turn implies 

that (other factors considered unchanged) real interest rates 

decline in response to expected future inflation. 

William Dewald (1983) presents data that suggest to him that 

real deficits, per se, have not been a critical factor in high 

real interest rates. Dewald's conclusion stems from an analysis 

that employs the deficit variable -- the real deficit relative 

to full employment output -- during the entire sample period. 

Dewald's examination of the cycle average data for both longterm and short-term real interest rates and for real deficits 

relative to high employment GNP shows no strong association

between real interest rates and real deficits. In the most recent 

cycle (1980:I through 1981:III) the long-term real interest rate 

averaged 4.5 percent, and the short-term rate average 4.7 percent,

very high relative to earlier periods, but the relative real 

deficit was about the same as in the preceding cycle. In prior 

cycles the long-term real interest rate hovered in the 2-3 percent 

range, while the short-term real rate was much more variable but 

remained rather low (ranging from -0.3 percent to 1.2 percent). 

The relative real deficit was about 1/3 of 1 percent through the 

1960s, about 0.8 percent in the early 1970s, and about 1.4 percent
- 39 -

from then on through the early 1980s (the largest relative real 

deficit in the sample period was in 1975:II). Thus, Dewald says 

this evidence tends to refute the conventional wisdom; the 

comparatively high real deficit during the period 1973:IV to 

1980:1 was not accompanied by comparatively high real interest 

rates. 

Dewald's econometric estimates with cyclical-average data 

indicate a positive relationship for both the long-term and the 

short-term real rate with the real relative deficit, but the 

relationship was insignificant for the short rate and only marginally significant for the long rate. In addition, measuring 

real rates and the deficit based on actual inflation, he found 

the real deficit had no significant effect on either the long or 

the short rate. He notes that a percentage increase in the relative real deficit was estimated to have nearly the same 1 percentage point effect on both long- and short-term real rates, but 

warns that the results are not very robust with respect to small 

changes in the sample period and in the definitions of the variables, and that only a fraction of the variation in the real 

interest rates is explained, suggesting that the results are 

biased because of variables left out of the analysis. However, 

his results indicate that when the relative real deficit is about 

1 - 1.5 percent, as in 1981-1982, it could account for only about 

1 - 1.5 percentage points of the real interest rate, which was 

averaging about 4.5 percent. 

Alan Blinder (1982) examines annual data for fiscal years 

1952-1981. On the basis of this time series evidence (a' la 

Granger and Sims), he cannot reject, in either of his regressions,

the hypothesis that growth in the publicly held government debt 

(measured by the unified on- and off-budget deficit) does not 

help predict real GNP growth. The estimated percentage change in 

real income in response to a 1 percent change in the debt is a 

small (between .06 percent and .13 percent) and statistically insignificant 

number. Therefore, he concludes that the growth in 

the national debt does not carry much information that is useful 

in predicting future real GNP growth. This result suggests that 

growth in the national debt does not carry much information that 

helps predict real interest rates. 

The context of Blinder's study is the question of the extent 

to which monetization of the deficit matters. His conclusion 

that the deficit does not help predict real GNP growth is derived

from an estimate in which the growth of bank reserves is held 

constant. He notes that his measure of the Federal deficit is 

nominal, in that it is not adjusted for the inflation related 

decrease in the real value of the outstanding debt, and that when 

he reestimated some of the regressions using the inflation corrected 

deficit, the explanatory power of the equations deteriorated 

enormously. 
- 40 -

Makin (1983) examines quarterly data on the 3-month Treasury 

bill rate from 1959-II to 1981-IV to detect an impact upon the real 

interest rate arising from an exogenous (i.e., as distinct from

cyclically induced) rise in fiscal deficits. He says his results 

regarding the possible significance of "crowding-out" can only be 

judged as "mixed to weak"; and that over the entire sample period 

the positive relationship found was only marginally significant. 

Several aspects of Makin's paper are interesting. He develops 

a macroeconomic model in the IS-LM format with some modifications 

and an aggregate supply function. He uses the model to show that

tests of the possible impact of fiscal deficits on interest rates 

conducted by inserting a measure of the fiscal deficit directly 

into an interest rate equation result in estimates biased downward 

and possibly negative, because deficits are endogenous and 

typically countercyclical, while interest rates are typically 

procyclical. 

Thus, correct procedure tests the impact on interest rates 

of the exogenous (i.e., policy induced) portion of the deficit. 

Makin notes that since the measured impact on interest rates of 

an exogenous shift in any spending component, such as exports,

should be identical to that of an exogenous shift in government 

expenditure, shifts in exports can measure the potential crowdingout impact of exogenous shocks to aggregate demand. 

Using a direct measure of the deficit, he estimates that a 

$100 billion deficit would elevate short-term interest rates by 

only about 10 basis points, an estimate he regards as biased

downwards. Reestimation using exports as an exogenous addition to 

demand indicated that a $100 billion exogenous rise in the deficit 

could elevate short-term interest rates by about 110 basis points 

(an estimate that is relatively close to the 70 basis points he 

reported in an earlier study). However, he notes that the 

statistical significance of this result is weak; it just barely 

avoids the judgment that these data reveal no relationship between 

the interest rate and the deficit. 

Ali Reza (1983) examines quarterly data on the average market 

yield of 1-year Treasury bills during the period December 1959 

through December 1982. He takes the Feldstein-Eckstein (1970)

study as his point of departure, introduces some changes in the 

model and measurement of the variables, and comes to rather 

opposite conclusions. 

His results suggest that the Federal deficit does not cause 

changes in either the real rate of interest or real output, and 

clearly does not increase either of them. Reza's analysis differs

from Feldstein-Eckstein in that Reza bases his estimates on a 

more general model -- he uses an IS-LM model with an aggregate 

supply function; he adjusts the interest rate for the effects of 

the marginal tax rate to obtain an after-tax rate of return; and
- 41 -

he uses the Livingston series as a measure of anticipated 

inflation rather than a distributed lag of past inflation. 

Although Reza's results are not conclusive, they are an 

interesting counterpoint to the Feldstein-Eckstein and the SinaiRathjens studies. Reza says the implication of his results is

that the private sector fully discounts future tax implications 

of government deficits -- rational behavior in view of the recent 

experience when the 1981 tax cut was followed by the 1982 tax 

increase in response to the large deficits experienced in 1981 

and forecast for subsequent years. Reza finds that exogenous 

government spending is the culprit in keeping interest rates high. 

Charles Plosser (1982) tests the hypothesis that a substitution of debt for tax financing crowds-out private investment by 

driving up the required rate of return -- i.e., driving down

the value of existing assets with fixed cash returns (e.g., 

bonds). He finds that there is little evidence that the way in 

which government expenditures are financed (taxes versus debt) 

is systematically related to movements in rates of return; unanticipated changes in government financing decisions appear to 

have no impact on asset values. In contrast, he finds consistent 

evidence that increases in government purchases are associated 

with higher interest rates. 

Plosser's analytical approach and basic assumptions are 

controversial. His investigation assumes capital markets are 

efficient (that is, expectations are rational) and examines asset 

price response to a shift from debt financing to tax financing of 

a given level of government expenditures. Thus, his empirical 

analysis of fiscal policy is from a different perspective than 

the more traditional studies which attempt to estimate structural 

models of the financial sector or aggregate consumption and saving 

behavior in response to fiscal policy shifts. 

The relationship he estimated is most significant for bonds 

with less than a year to maturity, a result he says suggests that 

such fiscal policy innovations have only a temporary impact. He 

notes that these findings may be interpreted as evidence of 

potentially interesting intertemporal substitutions induced by 

government spending. This interpretation, from the so-called 

rational expectations viewpoint, is that fiscal policy changes 

cannot effect permanent changes in macroeconomic behavior. 

William Fellner (1984) focuses on the fact that empirical 

estimates of the investment-reducing effect of deficits are 

overstated if they fail to account for a rise in savings that 

occurs in response to downward revaluations of the public's real 

net worth -- revaluations that in fact have accompanied deficits. 

He examines data for the period 1954-1982, under the assumption 

of a given level of aggregate nominal income -- that is, given

a monetary policy that offsets any additional expansionary or
- 42 -

restraining effect of fiscal policy. From these data he estimates 

that the factors which moderate the investment-reducing effect of 

budget deficits are more than negligible but are probably insufficient to neutralize the extent to which Federal deficits shift 

savings away from private investment. Thus, he views the size

of the projected future structural deficits to be troublesome, 

and suggests that deficit reduction measures should be directed 

at tilting the consumption-investment mix back toward investment, 

and that if additional taxes are needed they should be broadly 

based consumption taxes. This policy judgment is based on estimates that are admittedly crude, but are interesting nevertheless. 

On the basis of cycle-average data, he observes that compared 

to earlier years, the peak-to-peak period 1973-1979 has a significantly lower savings ratio while real public indebtedness

was rising rapidly. While recognizing that, because of inadequate 

controls this comparison is not conclusive, he notes that the 

observation is contrary to the prediction of the Ricardo/Barro 

theorem of the equivalence of tax and deficit finance. 

The foregoing sampling of recent econometric tests of the 

effect of real Federal deficits on real interest rates indicates 

that empirical studies of the issue are inconclusive. It is not 

surprising that it is difficult to isolate and measure a strong, 

clear-cut effect. As indicated above, even the task of measuring 

the essential concepts is as yet incomplete. Furthermore, there 

remains considerable controversy about fundamental questions that

must be addressed in modeling the complex economic relationships. 

Much of the theoretical and empirical research on the relationship 

between the Federal deficit and the interest rate is based on one 

or another variant of a Keynesian macroeconomic model. The 

Keynesian framework has been expanded, tested, and criticized 

over the past half century. To the extent that this model is 

unable to explain reality, it is questionable as a basis for establishing 

valid conclusions about the deficit/interest rate 

issue. To indicate the many issues about which serious scientific 

research continues to seek answers, the following pages are 

devoted to some of the more important parts of the ongoing debate 

about so-called mainstream macroeconomic relationships. 

THEORETICAL RESULTS FROM BASIC KEYNESIAN ANALYSIS

The basic Keynesian approach gives the result (except for 

the special case of the liquidity trap) that an increase in the 

deficit brought about either by an increase in government spending 

or a reduction in taxes has the effect of raising interest rates. 

Both the model and its result are subject to numerous and varied 

qualifications. An introduction to this voluminous literature 

can be found in a macroeconomics textbook such as Dornbusch and 

Fischer (1981) or Gordon (1982). Other general treatments can be 

found in Allen (1968), Evans (1969), and Lerner (1951). 
- 43 -

One of the basic analytical tools of Keynesian-type analysis 

is the IS-LM apparatus, which consists of equations showing

equilibrium conditions in the money market and the product market. 

The IS-LM equations are often used in theoretical and empirical 

analyses of the effects of deficits on interest rates and other 

variables. A primary source for the IS-LM apparatus is Hicks (1937). 

THE KEYNESIAN INVESTMENT AND CONSUMPTION FUNCTIONS

The Keynesian investment and consumption (savings) functions 

underlie the IS relation. Milton Friedman and David Meiselman 

(1963) produced evidence that cast doubt on the importance of 

investment as a determinant of cyclical behavior and on the 

stability of the Keynesian multiplier. Two major analyses of the 

consumption function are Ando and Modigliani (1963) and Milton 

Friedman (1957). Franco Modigliani and Richard Brumberg (1954) 

developed the life cycle hypothesis of individual saving behavior, 

which implies that the lifetime path of consumption is smoother 

than the lifetime path of disposable income. Further examinations 

of, and some disputes about, this theory appear in Modigliani 

(1966), Robert Hall (1978), and Sheldon Danziger, et al, (1980). 

A good source of numerous contributions (pro and con) to the 

debate about the Keynesian-type investment, consumption and saving 

functions (including, for example, the controversy about the 

extent to which saving responds to interest rate changes) can be 

found in various issues of the Brookings Papers on Economics 

(1972 to the present). 

EFFECT OF WEALTH IN DEFICIT/INTEREST RATE ANALYSIS

Explicit consideration of the effects of changes in the 

stock of wealth has proven to be significant for macroeconomic 

analysis. Models which fail to consider the roles of stocks of 

various types of wealth are suspected of being a biased basis for 

addressing the deficit/interest rate issue. Simple Keynesian 

models contain at most only an unsophisticated treatment of 

wealth. In such models changes in taxes affect disposable income, 

but the resulting changes in government debt implied by the 

change in the deficit are largely ignored. 

In the ongoing development of the Keynesian framework, the 

effects of wealth on macroeconomic variables such as consumption, 

and the demand for money, have been given increasing attention 

with explicit consideration given to wealth in the form of 

government bonds, privately issued bonds, real physical capital, 

and the money supply. Important sources for the treatment of 

wealth in Keynesian style models include Leijonhufvud (1968), 

Metzler (1951), Patinkin (1965), and Tobin (1961 and 1969). 

The standard IS-LM analysis is that substitution of deficit 

for tax financing (of a given level of government expenditures) 

increases aggregate demand. Examples of this approach are
- 44 -

Modigliani (1961) and Blinder and Solow (1973). In this analysis 

it is assumed that the government bonds issued to the public to 

finance the deficit increase private wealth, and because increases 

in wealth increase current consumption, aggregate demand is

given a further boost. However, because of this boost to current 

consumption, the increase in private saving is less than the bond 

issue and, therefore, real interest rates rise and crowd out some 

private investment. As a result, the rate of capital accumulation 

falls and future generations have a smaller capital stock. 

Researchers have found several bases for casting doubt on this 

analysis and conclude that deficit increases result in a rise in 

real interest rates and crowd-out private investment. 

Barro (1974) argues that the standard analysis is incorrect 

because it does not recognize that future taxes required to 

service and retire the debt imply that there is no net wealth 

effect associated with the issue of government debt. This implies 

that there is no difference between financing government spending 

by taxes or by debt. Empirical studies attempting to settle the 

theoretical dispute remain controversial. 

Some of these studies work within the IS-LM structure. 

These include Buiter and Tobin (1979) and Feldstein (1982), who 

conclude that the public considers the government bonds they hold 

to be wealth, but the findings of Kochin (1974), Kormendi (1978), 

and Tanner (1979) find that the data suggest that government 

bonds are not wealth (do not influence aggregate consumption). 

As indicated earlier, Plosser (1982) considers the issue from a 

different perspective and investigates the response of asset 

prices in an efficient capital market. He estimates the extent 

to which a substitution of debt financing for tax financing is 

associated with an increase in interest rates. He concludes that 

the evidence suggests that asset prices are unrelated to how the 

government finances its expenditures, and thus that government 

bonds are not wealth. 

DEMAND FOR MONEY IN KEYNESIAN MODELS

The behavior of the demand for money, especially as a function 

of interest rates, is the heart of the LM relation and thus is 

critical in the Keynesian analysis of the effects of an increased 

deficit on interest rates. The primary means by which an increase 

in the deficit raises interest rates in the basic Keynesian model 

is by increasing nominal demand, and thereby increasing the demand 

for money to support the higher volume of nominal transactions. 

Given an unchanged supply of money, if the demand for money is 

very insensitive to variations in interest rates, that is, if a 

bigger increase in interest rates is needed to bring money demand 

down a given amount, the degree to which interest rates rise in 

the Keynesian model for a given increase in the deficit will be 

larger. 
- 45 -

There is theoretical disagreement as to whether the interest 

rate affects the demand for money. Econometric tests generally 

show there is an effect, but the magnitude remains a matter of 

controversy and studies continue. 

A substantial volume of literature has been written about 

theoretical and empirical aspects of the demand for money. Three 

articles containing theoretical material are Baumol (1952) and 

Tobin (1956 and 1958). Empirical literature on the demand for 

money is also extensive. Three references are M. Friedman (1959), 

Goldfeld (1973), and B. Friedman (1978). 

QUANTITY THEORY CRITICISM OF KEYNESIAN MODELS

Milton Friedman and other "monetarists" question Keynesian 

theory on monetary grounds. Friedman (1956) presents the elements 

of this theoretical approach. 

In a number of NBER studies during the nineteen-sixties, 

Friedman and Anna J. Schwartz investigated the relationship 

between money and cyclical behavior. They found that the changes 

in money income and prices that marked every major episode (deep 

depressions or major inflation) in U.S. economic history were 

"accompanied by a change in the rate of growth of the money 

stock, in the same direction and of appreciable magnitude." 

Inasmuch as this "cannot consistently be explained by the contemporary changes in money income and prices," either it must 

stem from coincidence or "it must reflect an influence running 

from money to business." (Friedman and Schwartz, 1956). 

A symposium on Friedman's theoretical framework was published 

in the Journal of Political Economy (1972). This symposium 

included contributions by Brunner and Meltzer, Tobin, Patinkin,

and a reply to his critics by Friedman. 

Brunner and Meltzer (1972) also develop an alternative to 

the standard IS-LM framework. Their model includes two asset 

markets (rather than just a money market) and the prices of real 

assets, financial assets, and output. Thus they can analyze the 

substitutions between money, bonds, real capital, and current 

consumption that occur as adjustments to changes in monetary or 

fiscal policies or by autonomous changes in the productivity of 

capital. They can analyze also the interrelation of asset prices, 

output prices, and interest rates. 

In addition, they develop an analysis of the credit market 

and its interaction with the rest of the economy and use it as 

a price theory explanation of persistent or "involuntary" 

unemployment. In their model the credit market is the main link 

between the government and the private sector, and they explicitly 

consider the effects on assets and output of financing the 

government's budget. In contrast to the Keynesian paradigm, the
- 46 -

relative responses to monetary and fiscal policy in their model 

do not depend on the interest elasticities of the IS or the LM functions. 

Nor is the real balance effect crucial for a positive 

response of output to changes in money or the monetary base; the 

dominant wealth effect induced by monetary (and some fiscal) 

policies is a change in the price of output (the price level). 

A constant, maintained budget deficit financed by issuing debt 

raises market interest rates and the price of real capital. 

LOANABLE FUNDS (FLOW-OF-FUNDS) ANALYSIS

Frequently the effects of deficits are analyzed in terms of 

loanable funds, especially when the analysis is concerned with 

very short-term impacts of deficits on financial markets. The 

issuance of bonds by the government for the purpose of financing 

an increase in the deficit is said to increase the demand for 

loanable funds, and if the supply of loanable funds does not 

increase by the same amount, interest rates will rise. Whether 

or not the supply of loanable funds will increase by the same 

amount as the demand depends on the extent to which the future 

liabilities implied by the new bonds are taken into account and 

whether the bonds are regarded as wealth. If the future liabilities 

completely offset the current wealth in the bonds, in most situations (aside from incentive effects) saving and the supply of 

loanable funds should rise by the same amount as the demand, and 

interest rates should not have to change to bring supply and

demand into balance. This subject is discussed in Tsiang (1956) 

and in the references to the Ricardo/Barro "equivalence theorem."

CROWDING-OUT

Benjamin Friedman (1978) analyzes the financial market 

aspects of the question whether Federal Government deficits crowdout private investment spending. His model assumes that: monetary 

policy does not accommodate the increase in the deficit; the 

economy is operating at less than full capacity (at full employment, additional debt financed government spending induces inflation and thus displaces some private spending); and that higher

utilization rates induced by government spending do not have an 

"accelerator effect" which would result in an increase in the 

desired capital stock. Friedman examines two financial market 

phenomena: transactions crowding-out and portfolio crowding-out. 

To the extent that an increase in the fiscal deficit stimulates aggregate demand, it increases the demand for money to 

finance the larger volume of transactions, which raises interest 

rates, thus discouraging some private spending. This result is 

moderated to the extent that the demand for money decreases (the 

velocity of money increases) in response to the rise in the
-47 -

interest rate -- so interest rates rise less -- and the extent 

to which the demand for investment goods is insensitive to the 

rise in interest rates. Friedman's statistical estimates indicate 

that, in the short run, transactions crowding-out is minor, and 

although it increases in the longer run it discourages less than 

half of the potential fiscal impact of the deficit. 

Portfolio adjustments can occur as a result of an increase 

in the deficit financed by government bonds sold to the public. 

Friedman's analysis, building on the work of Tobin, examines a 

model with 3 assets: money, government bonds and private capital

ownership. This model is sufficiently general to yield ambiguous 

results of the portfolio adjustment effect of a deficit increase 

on private investment. 

The public may respond to the increased volume of bonds in 

their portfolios by seeking to increase its desired holdings of 

cash or real capital. Increased demand for real capital tends to

reduce the required return on investment, thus promoting real 

capital accumulation. In contrast, increased demand for more 

cash holdings tends to raise interest rates on government debt, 

making investment in real capital less attractive. The outcome 

depends on whether money or private capital ownership is the 

closer substitute for government debt. Portfolio crowding-out of 

private capital formation necessarily follows if investors view 

government securities and capital as perfect substitutes. Some 

Keynesian models, such as Blinder and Solow (1973), assume this 

is the case, but this assumption is shown to be neither theoretically nor empirically valid. On the other hand, portfolio 

crowding-in of private capital formation necessarily follows if 

an increase in wealth does not increase the demand for cash. 

But Friedman presents empirical evidence that wealth does influence money demand. Friedman emphasizes that there are no conclusive findings as to whether actual behavior results in portfolio 

crowding-out or portfolio crowding-in. 

However, Friedman suggests that short- and long-term government securities may have different relative substitutabilities 

with cash and capital -- short-term Treasury bills are perhaps

more like money, while very long-term Treasury bonds are more 

likely to provide investors with substitutes for long lived 

capital goods. To the extent this is the case, debt management 

practices that finance a deficit with very short-term rather 

than long-term securities would be less likely to crowd-out 

private capital investment. 

Other references on the subject of portfolio crowding-out 

are Roley (1979, 1981, and 1982). These papers also provide 

useful references to empirical and theoretical research in this 

area. 
- 48 -

IMPLICATIONS OF GROWTH IN THE FEDERAL DEBT

Prolonged large Federal deficits create the risk that the

Federal debt will account for a large and growing share of the 

total credit market indebtedness of U.S. nonfinancial borrowers.

Benjamin Friedman (1983) notes that the economy's total debtto-GNP ratio has remained relatively constant (displaying no trend 

and little cyclical fluctuation) since the end of World War II. 

However, despite the relative stability of the total, the components -- the private sector debt-to-GNP ratio and the Federal 

debt-to-GNP ratio -- fluctuate. Neither component shows a stable 

relationship to GNP, but their movements have been offsetting, so 

the total has remained a rather constant 1.45 percent of GNP. 

Friedman traces the Federal debt-to-GNP ratio, noting a 

decline from 103 percent in 1946, to 63 percent in 1953, to the 

24-29 percent range in the 1970s through 1982 -- which he compares

to the 27 percent rate in 1918. However, he points out that the 

declining trend stopped in the mid 1970s, has turned up in FY 1983, 

and is projected to rise further through FY 1988. The rising 

Federal debt-to-GNP ratio reflects a path of deficits that is 

relatively large compared to nominal GNP growth resulting from 

either real output growth or inflation. Given the rather constant 

total debt-to-GNP ratio, the rise in the Federal debt ratio 

implies a falling private debt-to-GNP ratio. 

He puts the projected decline in the private debt ratio in 

the perspective of the 1956-1980 period during which the noncorporate business sector (which accounts for about three-quarters

of U.S. plant and equipment investment) used borrowing to fund 

about 64 percent of its net financial requirements. Thus, Friedman concludes 

that in the absence of a major change in financing 

patterns, the build-up of the Federal debt-to-GNP ratio implies 

less debt available to finance the private capital accumulation 

necessary to increase the nation's capital intensity (the capital 

stock-to-total output ratio). By focusing on the debt-to-GNP 

ratio Friedman adjusts for actual inflation rather than properly 

accounting for expected inflation, and it is not clear whether he 

makes a par to market value adjustment, but nevertheless his main 

conclusions deserve consideration. 

Frank de Leeuw and Thomas Holloway (1983) also explore the 

buildup of Federal debt resulting from sustained deficits. Based 

on the level of real GNP at its mid-expansion point in the cycle,

they estimate a "mid-expansion trend GNP path," which removes 

cyclical fluctuations, but preserves the average level of real 

GNP growth over the period 1953-80. Based on this trend real 

GNP path, they estimate a time series of the cyclically adjusted 

Federal deficit and the cyclically adjusted Federal debt. 
- 49 -

To analyze the long-run "crowding-out" of private investment, 

de Leeuw and Holloway prefer to represent the role of the Federal 

budget by an estimate of the market value of the stock of publicly 

held Federal debt rather than the current deficit flow. This 

analytical preference stems from the fact that the stock of 

government securities, not the current deficit, is a substitute 

for capital stock in the public's asset portfolio (as noted above 

in Friedman's analysis of crowding-out). The choice is important 

because the Federal deficit-to-GNP ratio need not move in the 

same direction as the Federal debt-to-GNP ratio. 

Rather than use actual data, they use cyclically adjusted 

data because the growth of the trend (cyclically adjusted) debt 

relative to trend GNP is important for the analysis of the impact 

of the budget on productivity and growth. And, focusing on 

changes in the cyclically adjusted debt-to-trend GNP ratio is 

similar to analyzing the effect of the real (rather than the 

nominal) deficit by including real (rather than nominal) interest 

payments to account for changes in the real value of outstanding 

Federal debt. 

Of course, the cyclically adjusted Federal debt is the 

cumulation of annual cyclically adjusted Federal deficits. So it 

is important to note that the de Leeuw and Holloway estimate of

the cyclically adjusted Federal deficit tends to be higher than 

alternative measures such as the BEA's published high employment 

budget (measured at a 4.9 percent unemployment rate) or even a 

high employment budget based on a 6 percent unemployment rate. 

For example, for 1983, when the actual deficit was 5.6 percent of 

actual GNP, the de Leeuw and Holloway cyclically adjusted deficit 

was 4 percent of "mid-expansion trend" GNP, whereas the BEA high 

employment deficit was 1.5 percent of high employment GNP, and 

the high employment budget at 6 percent unemployment was 2.5 percent of the corresponding high employment GNP. 

The de Leeuw and Holloway estimates indicate that increases 

in the cyclically adjusted Federal debt-to-trend GNP ratio during 

1981-83 were due, about equally, to the differential between the 

interest rate on Federal debt and the GNP growth rate, and to 

explicit policy decisions about Federal receipts and expenditures. 

The major policy decisions were cuts in personal and corporate 

taxes, and increases in defense spending. de Leeuw and Holloway 

project that, under a wide range of assumptions about interest 

rates, GNP growth rates, and budget decisions, the cyclically 

adjusted Federal debt-to-trend GNP ratio will increase during the 

period 1983 to 1988. 

POTENTIAL INSTABILITY

Sargent and Wallace (1981) have pointed out that persistent 

deficits cause an increase in the Federal debt-to-GNP ratio that 

can be unstable. If Federal expenditures other than interest
- 50 -

payments on the Federal debt are a larger share of GNP than are 

Federal tax receipts (that is, there is a so-called "primary 

deficit"), and if the interest rate on the Federal debt exceeds 

the growth rate of GNP, interest payments on the Federal debt 

become a progressively larger share of GNP. The Federal debt-toGNP ratio rises because of the need to finance the persistent 

primary deficit and the ever growing interest bill. Sargent and 

Wallace suggest that as this process continues, so does the 

pressure to monetize the debt. Monetization would bring inflation, 

which would reduce the real value of the debt and thereby reduce 

the real value of interest payments on the debt. But inflation 

could accelerate unless expenditure reductions and/or tax increases 

reduced the primary deficit and allowed the monetization process 

to stop. 

James Tobin (Conference Board, 1983) analyzes the dynamics 

of Federal deficits and debt using a model similar to the one 

examined by Sargent and Wallace. He focuses attention on an

equation that describes the growth of the Federal debt-to-GNP 

ratio. This equation shows the crucial relationship between the 

real interest rate on Federal debt and the growth rate of real 

GNP. The assumption of reasonable values for the parameters in 

the equation permits the calculation of a "steady state" or 

"stationary" value of the debt-to-GNP ratio, the level at which 

the ratio would stop rising, as long as the growth rate of real 

GNP exceeds the real interest rate. 

Tobin also uses the model to estimate the path of the Federal 

debt-to-GNP ratio for various periods from 1952 to the present. 

For example, for the 1980-81 period, he calculates the actual 

debt-to-GNP ratio to be 26.5 percent. Using parameter values from 

that period he estimates that after 5 years the ratio would rise 

to 29.1 percent and to 31.6 percent after 10 years, and that the 

hypothetical "stationary" level of the ratio is 80 percent. 

While rather imprecise, these estimates are commensurate with 

those of de Leeuw and Holloway mentioned above. 

Tobin also suggests that, rather than allowing the debtto-GNP ratio to rise to the maximum level implied by the situation 

in 1980-81, policy steps could be taken to stabilize the ratio at 

about 30 percent. He says this would require reducing the primary 

deficit to 0.6 percent of GNP. But, he says, the key is to reduce 

the real (after tax) interest rate to 1 percent, by a one time 

monetary injection, which would raise the Fed's monetization of 

the debt and future deficits to about 17 percent (a level much 

closer to historical practice than is current policy). 

MONETIZATION OF THE DEFICIT

Macroeconomic analysis generally concludes that important 

consequences depend upon the extent to which the Federal debt is 

monetized. The search continues for conclusive evidence on
- 51 -

several related questions. One is the extent to which monetization 

affects real versus nominal GNP. Another question is what factors 

determine the extent to which the Fed will monetize the deficit. 

As Alan Blinder (1983) puts it, the first question amounts

to asking, "do open market operations matter?" That is, for a 

given budget deficit, will real or nominal GNP behave differently 

depending on whether the new bonds are bought by the Fed or the 

public? Blinder presents the traditional analysis and then 

reviews some recent theoretical literature which indicates that 

the answer is ambiguous when the dynamics of wealth effects,

supply-side effects, and expectational effects are considered. 

To resolve the ambiguity, he presents time series evidence (see 

page 12 above) which supports the idea that monetization matters 

mainly as a predictor of future growth in nominal, but not real, 

GNP. In addition, Blinder finds only mixed evidence that a 

monetary base variable helps predict inflation, once growth in 

government debt is accounted for. 

Since the extent of monetization is considered to be an 

essential consideration in estimating the extent to which deficits 

might be connected to the process of inflation, Blinder also

reviews recent studies of the extent to which deficits are associated with increased money growth. He finds the evidence mixed --

no firm conclusions about the determinants of monetization. 

His own estimates, based on data for the period 1961-1981, indicate that about 6-1/2 percent of a nominal deficit would be 

monetized, after accounting for the effects of inflation and the 

annual growth of government purchases, both of which tend to 

decrease the fraction of the nominal deficit that is monetized. 

These estimates are similar to those reported by Mickey Levy (1981).

However, when Blinder based his estimates on the inflation adjusted 

deficit, that variable showed no relationship with money growth. 

Both the Blinder and the Levy papers provide succinct reviews of 

and further references to the literature on this topic. 

As was mentioned in the section above on "potential instability," the buildup of the Federal debt-to-GNP ratio increases 

the pressure to monetize the debt. Indeed, Sargent and Wallace 

(1981) show that under some circumstances, a relatively large 

Federal debt severely constrains the ability of monetary policy 

to control inflation. Tight money now will result in future 

inflation higher than it would be with looser monetary policy 

now, because tighter money means greater reliance on bond finance. 

This in turn means that the debt will be larger at some specified 

date in the future when monetization will, by assumption, begin. 

The larger the debt, the more monetization will be required, and 

the greater the inflation that will result. To the extent that 

this chain of events is anticipated and results in an increase

in the monetary base, tighter money now could result in more 

inflation now. In addition, Preston Miller (1983) argues that 

even if the Federal Reserve does not formally monetize the debt,
- 52 -

higher interest rates make it profitable to hold interest bearing 

assets that are as risk-free as money and that can be used 

essentially as money in transactions. Thus the private sector 

introduces and trades in such instruments and effectively monetizes 

the debt. 

EFFECT OF WAGE-PRICE BEHAVIOR IN DEFICIT/INTEREST RATE ANALYSIS

The analysis and prediction of wage-price behavior continues 

to be an area of great controversy. Assumptions about such 

behavior can be crucial to conclusions about the deficit/interest 

rate issue. It tends to be true, for example, that neoclassical 

models assume that wages and prices are much more flexible in the 

short run than Keynesian models. Consequently, neoclassical 

macroeconomic models are much more similar to microeconomic 

general equilibrium models, and they tend to allow more room for 

incentive effects to operate. As a result, in such models the 

effects of an increase in the deficit brought about by a tax cut 

are more supply-side oriented, and the demand-side effects which 

may raise interest rates are less pronounced. For more on these 

complicated issues see Barro and Grossman (1971), Clower (1965), 

and Leijonhufvud (1968). An early article on wages in the 

Keynesian system is Keynes (1939). An important and controversial 

strand of the Keynesian tradition is the Phillips curve, which 

postulates that less unemployment leads to faster wage increases. 

The basic article for this approach is Phillips (1958). Other 

very fruitful sources are E. Phelps (1970 and 1972), R. Gordon 

(1983), M. Baily (1983) and J. Taylor (1983). 

RELATIVE PRICE EFFECTS OF TAXES IN DEFICIT/INTEREST RATE ANALYSIS

The effects of taxes on prices and hence resource allocation 

also can be crucial to conclusions about the deficit/interest 

rate issue. As pointed out by a number of authors, the subject

is treated inadequately at best in Keynesian-type analyses. Dale 

W. Jorgenson (1962) presented data to show that "the central 

feature of the neoclassical theory is the response of the demand 

for capital to changes in relative factor prices." In later work 

with Robert E. Hall, Jorgenson presented empirical evidence that 

investment was responsive to tax treatment (Jorgenson and Hall, 

1967). Arnold Harberger, (1962, 1964, and 1974) utilizing concepts 

originating with Marshall and Walras, analyzed the way in which 

differential taxes contribute to inefficiency, and estimated the 

loss of efficiency associated with the corporate income tax. 

RATIONAL EXPECTATIONS

As was indicated earlier, an important qualification to the 

standard Keynesian model that serves as a basis for much of the 

discussion of the deficit/interest rate issue is the growing 

literature on rational expectations. In a series of articles, 

Robert E. Lucas and Edmund S. Phelps developed a formal theory of
- 53 -

aggregate supply based on the methods used by economic agents to 

distinguish relative from absolute price changes. This theory 

allows for information lags and adjusted costs (see for example 

Phelps, 1970, and Lucas, 1973). 

Thomas Sargent and Neil Wallace (1975) have offered an alternative formulation in which aggregate output varies with the 

difference between the actual current general price level and

the general price level that people expected, in the last production period, to prevail during this production period. 

More recent contributions, for example Blinder (1981), indicate that even anticipated money-supply changes can exert real 

output effects when the rational expectations paradigm is extended 

to the behavior of inventories. 

The empirical studies of Friedman and Schwartz did not 

decompose the effects of money growth rate changes into their 

real and nominal components or identify the link between the 

formulation of people's expectations and the dissipation of real 

effects. In an effort to fill this gap, Leonall Andersen and 

Denis Karnosky (1973) examined the relationship between percentage 

changes in the money supply and percentage changes in prices and 

in real output. They found that permanent changes in monetary 

growth tend to be followed by "a sharp and substantial positive 

response of output growth for five quarters," whereas it takes 

the rate of price inflation at least 20 quarters to adjust. 

In a later study, John Rutledge (1980) examined the effects 

of changes in the growth of money -- separated into anticipated 

and unanticipated components -- on prices and real output. He 

found that the adjustment of real output to an unanticipated 

change in the growth of money is about the same as the adjustment 

of prices to an anticipated change in the growth of money. Both 

take about eleven quarters to work themselves out. Robert Barro 

has estimated that an unanticipated rise of 1 percent in the 

growth of money will generate, in the same year, about a .36 percent rise in the price level and almost a 1 percent rise in real 

output. The price effect and the real output effect take, 

respectively, five years and two years to work themselves out. 

CONCLUSION

Although not an exhaustive survey of the literature, the 

foregoing bibliographic notes acquaint the reader with a reasonably comprehensive sample of economic research on the relationship between the Federal deficit and interest rates, including 

references to the issues in macroeconomic theory that form the 

context of the discussion. The review of this sample indicates 

that controversy prevails, and the issue is yet to be settled in 

either the theoretical or empirical literature. 
- 54 -

REFERENCES

Allen, R. G. D., 1968, Macro-Economic Theory, New York: 

St. Martin's Press.

Andersen, L. C., and Karnosky, Denis S., 1973, "The Appropriate Time 

Frame for Controlling Monetary Aggregates: The St. Louis Evidence," 

in Controlling Monetary Aggregates II: The Implementation, Boston: 

Federal Reserve Bank of Boston.

Ando, Albert, and Modigliani, Franco, 1963, "The 'Life Cycle' 

Hypothesis of Saving: Aggregate Implications and Tests," The American 

Economic Review, March.

Baily, Martin N., 1983, "The Labor Market in the 1930s," MacroEconomics, Prices and Quantities, James Tobin, ed., Brookings 

Institution.

Barro, Robert, 1974, "Are Government Bonds Net Wealth?", Journal 

of Political Economy, November/December.

Barro, Robert, 1980, "Unanticipated Money and Economic Activity: 

Results from Annual U.S. Data," in Fischer, S., Ed., Rational 

Expectations and Economic Policy, Chicago: University of Chicago 

Press. 

Barro, Robert, and Grossman, H., 1971, "A General Disequilibrium 

Model of Income and Employment," The American Economic Review,

March.

Baumol, William J., 1952, "The Transactions Demand for Cash: An 

Inventory-Theoretic Approach," Quarterly Journal of Economics,

November.

Blinder, Alan S. and Solow, Robert M., 1973, "Does Fiscal Policy 

Matter?" Journal of Public Economics-2.

Blinder, Alan S. and Solow, Robert M., 1974, "Analytical Foundations 

of Fiscal Policy," The Economics of Public Finance.

Blinder, Alan S. and Solow, Robert M., 1976, "Does Fiscal Policy 

Matter? A Correction," Journal of Public Economics-5.

Blinder, Alan S., 1981, "Inventories and the Structure of Macro 

Models," The American Economic Review, May.

Blinder, Alan S., 1982, "On the Monetization of Deficits," National 

Bureau of Economic Research, Working Paper # 1052, December.
- 55 -

Brunner, Karl, and Meltzer, Allan H., 1972, "Friedman's Monetary 

Theory," Journal of Political Economy, Sept./Oct.

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December.
PART III

INTEREST RATES AND THE FEDERAL DEFICIT:

SOME EMPIRICAL TESTS
PART III

INTEREST RATES AND THE FEDERAL DEFICIT:

SOME EMPIRICAL TESTS

INTRODUCTION

This paper presents empirical tests of the hypothesis that 

higher Federal deficits raise real interest rates. The tests 

make use of a particular type of equation for the determination 

of interest rates which is presented in Feldstein and Eckstein 

(1970). In the first stage of the analysis, the FeldsteinEckstein equation is estimated over the same sample period as in 

the original article using the same data concepts, and then 

reestimated for the period 1965 Q1 - 1983 QII, the sample used 

in this paper. The reestimation indicates that the equation 

fits poorly in the latter period, and therefore needs to be 

respecified if it is to be used for testing the relationship in 

the more recent past. This is done in the second section. 

Finally, the tests for the effects of the deficit using this 

equation are presented in the last section. The results of the 

tests indicate that judging by the econometric techniques employed 

in this paper, high deficits have had virtually no relationship 

with high interest rates in this time period.

EXTENDING THE FELDSTEIN-ECKSTEIN ANALYSIS

The interest-rate equation used for the tests in this paper

is based upon the type of equation in Feldstein and Eckstein 

(1970). This equation has been used with variations by other 

authors, including Feldstein and Chamberlain (1973) and Sinai and 

Rathjens (1983). Such an equation can be developed from a simple 

modified LM curve giving the condition for equality of the supply 

of and demand for the monetary base. This LM curve can be written 

in implicit form as

G(i-pe,m,x,z)-m=0 (1)

where i is the nominal interest rate, pe is the expected inflation

rate so that i-pe is the real interest rate, m and x are the 

logarithms of the real monetary base and real output respectively, 

z is a vector of additional variables, and the function G is the 

demand for m. Equation (1) can be solved to isolate the real 

interest rate on the left-hand side for purposes of estimation:

i-pe=F(m,x,z) (2)
- 64 -

Several variables are included in z. If the Federal deficit 

affects interest rates, z should include a measure of the level 

of debt or the change in debt, that is, the deficit. When the 

government runs a deficit and issues bonds to finance it, private 

individuals or institutions can purchase these bonds by reducing 

either their level of consumption, or their holdings of money 

balances, or their holdings of assets representing claims on 

real private capital. If these government bonds are substitutes 

for real private capital in the portfolios of investors, they

will be purchased largely by reducing investment. In such a 

case investment and capital intensity will decline, and the 

marginal product of capital and real interest rates will rise.

However, if the bonds are perceived as generating future 

liabilities, such as a future tax burden, these liabilities may 

bring about reduced consumption and increased private saving

which could be used to purchase the bonds, leaving real interest 

rates and real private investment unchanged. More on these and 

related issues can be found in various articles surveyed in the 

companion survey of literature on the subject. 

In addition, z should include pe. This is because an 

increase in expected inflation lowers the return to holding 

money, thereby inducing a shift in portfolios away from real 

money balances. This reduction in the holding of wealth in the 

form of money could lead to an increase either in consumption or 

in investment. Insofar as investment increases, there is an 

increase in capital intensity and a reduction in real interest 

rates. Moreover, higher inflation rates tend also to be more 

highly variable, and in general, periods of high inflation have 

tended to be more unstable, both because of the volatility of

the inflation rate itself, and because of the volatile nature

of government policy responses to high inflation. Such volatility 

increases risk and could result in less innovation and technical 

change, in which case the productivity of capital and real interest 

rates would tend to be relatively lower. Hence these arguments 

lead to the conclusion that higher expected inflation brings

about lower real interest rates.

In contrast to this discussion, in an equation such as 

equation (2) it is possible that higher anticipated inflation 

leads to higher real interest rates rather than lower ones. 

This could happen if a proportional tax is applied to interest 

income in nominal terms and nominal interest payments are deductible.l/ The tendency of inflation to raise real interest rates 

would be stronger insofar as the tax system is progressive, not 

indexed, and therefore marginal tax rates on interest income 

increase with inflation through bracket creep. Thus, a priori 

it cannot be said whether an increase in expected inflation

 

1/ Tax effects of this sort are examined in Darby (1975), 

Feldstein (1976), Peek (1982), and Tanzi (1980).
- 65 -

raises or lowers real interest rates. In Sections II and III 

equations will be presented which use both the before-tax and 

after-tax interest rate.

The vector of variables z should also include a measure of 

volatility in financial markets. This is because increased 

volatility raises risk for investors, who therefore insist on 

higher risk premiums in real interest rates (in addition to 

higher risk premiums in nominal rates), thus causing real 

interest rates to rise.

The above discussion suggests that equation (2) be written 

in linear form as:

i-pe=ß0+ßlm+ß2x+ß3d+ß4pe+ß5s+u (3a)

where d is a measure of Federal debt or the deficit, s is the 

measure of financial market volatility, and u is a disturbance. 

It is hypothesized that ß1<0 and ß2,ß5>0. If the deficit 

raises real interest rates, ß3>0. As noted above, the sign

on ß4 is ambiguous. Finally, following Feldstein and Eckstein, 

in this style of equation pe is measured as a distributed lag 

on the inflation rate p2/, and so after moving pe to the righthand side, equation (3a) becomes

 i=ß0+ß1m+ß2x+ß3d+(1+ß4)π(L)p+ß5s+u (3b)

where π(L) is a polynomial in the lag operator L, with the sum 

of coefficients equal to unity. It is understood that variables 

other than p may also enter the equation with lags.

In this equation the coefficient on the lag on inflation, 

1+ß4, may not equal unity. If it does not, the Fisher effect, postulating 

that changes in inflationary expectations are equally 

reflected in changes in nominal interest rates, would not hold. 

On the other hand, over certain periods ß4 may be near 0. This 

could happen, for example, when inflation is relatively low and 

stable, and has little effect on investment or on marginal tax 

rates.

Nevertheless it should be clear that, in general, whatever 

is the value of ß4 when the interest rate is defined to be 

before-tax, it should decline and be negative when the same 

equation is estimated using an after-tax interest rate. This 

follows from the fact that using an after-tax interest rate

 

2/

Distributed lags on inflation were also used in Yohe and 

Karnosky (1969).
- 66 -

removes from the equation the effects of inflation through taxes 

on before-tax interest rates.

On balance, the existing empirical evidence from a number 

of studies indicates that ß4 tends to be negative in most time 

periods even when a before-tax interest rate is used.3/ In many 

cases 1+ß4 is substantially below unity. Therefore, in the 

equations done here, 1+ß4 is expected to be below unity when 

a before-tax interest rate is used, and to decline even more

when an after-tax interest rate is used instead. 

Equation (3) is estimated using quarterly data for the 

sample period 1965 QI - 1983 QII. The first step in this estimation is to reproduce as closely as possible Feldstein-Eckstein's 

specification of this equation (equation (10) in their article) 

for their original sample 1954 QI - 1969 QII, and test whether 

that specification is suitable for the later sample period. In 

reproducing the equation, except as noted below the variables are 

defined as nearly as possible to be the same as in FeldsteinEckstein, so far as could be determined from their description

in the original article. Of course there have been data revisions since their paper was written. The revised data are used 

here, so some differences from their results can be expected on 

the basis of these revisions alone. Similarly the estimation 

technique is as near to theirs as could be determined from their 

paper.

The following variables are used. For i the variable used 

is RI, the interest rate on seasoned Moody's AAA corporate bonds. 

Some of the independent variables are measured in real per

capita terms; in each case this is done by dividing by the 

implicit price deflator for GNP and by the resident population. 

m is HPNL, the logarithm of the real per capita monetary base, 

using monetary base data from the Federal Reserve Bank of

St. Louis. x is QNL, the logarithm of real GNP minus real GNP 

produced in the government sector, all on a per capita basis. 

This is a measure of real output produced in the private sector. 

d is DPNL, the logarithm of real per capita interest-bearing 

public debt securities held by private investors plus matured 

public debt and debt bearing no interest. There were changes in 

the definition of this series around 1968, and after 1968 QIII 

these data are spliced with old series embodying the same concepts. p is PCG, the percent change from the previous quarter 

at an annual rate of the implicit price deflator for personal 

consumption expenditures. This differs from the specification 

used by Feldstein and Eckstein, since they do not annualize the 

growth rate. 

 

3/ See Fisher (1930), Pearce (1979), Summers (1983), and Wood 

(1981). 
- 67 -

Following Feldstein and Eckstein, the variable RID lagged one 

quarter is included, where RID is the first difference in RI. As 

discussed by them, such a variable measures expected changes in

interest rates. As such it captures some but not all of the 

instability in financial markets that the variable s represents. 

No other measure of s is included.

Table 1 contains ordinary least squares estimates of the 

original Feldstein-Eckstein specification of equation (3) (equation (10) in their paper) using the data described above for

their original sample period 1954 QI - 1969 QII, for the period 

1965 QI - 1983 QII, and for the entire sample 1954 QI - 1983 

QII. In Table 1 these three estimates are numbered equations 

(4), (5), and (6), and they differ only in that they are for 

different sample periods. The distributed lag on PCG(-1) is a 

third-degree polynomial distributed lag with no endpoint constraints. The ai are the lag coefficients for this distributed 

lag. In these and all equations in this paper the t-ratios are 

in parentheses beneath the coefficients.

Equation (4) is, on balance, fairly close to the original 

equation (10) of Feldstein and Eckstein.4/ The most striking 

difference, however, is that the sign on the debt variable has 

switched to negative, while at the same time this variable is

significant. A negative sign, of course, says that more real 

debt per capita lowers interest rates. This switch in sign 

suggests that the influence of government debt in this equation 

over this sample is uncertain at best. 

Equation (5) for the sample 1965 QI - 1983 QII differs from 

equation (4) in several respects. The coefficients on HPNL and 

QNL are much larger in absolute value. The debt term is still

negative, and now it is highly significant. The RID(-1) term 

is very weak and of the wrong sign. And the coefficients on

the price terms sum to a negative number. These results imply 

that this particular specification of equation (3) is unstable 

over time, and the equation needs to be respecified if it is to 

be of use in the later sample period. Moreover, the low DurbinWatson statistic suggests that the equation needs to be corrected 

for serial correlation. Equation (6), run for the entire sample 

1954 QI - 1983 QII, confirms these conclusions. Here the debt 

variable switches back to its original sign. However the DurbinWatson statistic is far too low.

 

4/ As in their original equation, the sum of lag coefficients 

on PCG indicates that a change in expected inflation changes the 

interest rate by about the same amount. As noted before, this 

result is different from most empirical work, which gets a 

coefficient below unity.
- 68 -

 Table 1

 Estimates of the Feldstein-Eckstein 

 Specification of the Interest-Rate Equation

Equation Number 4 5 6

Dependent Variable RI RI RI

Sample 1954QI-1969QII 1965QI-1983QII 1954QI-1983QII

Estimation Method OLS OLS OLS

Independent Variables:

Constant -46.3140 -699.232 -70.6909

 (-10.78) (-11.34) (-2.70)

HPNL -5.4290 -66.9358 -10.7192

 (-8.36) (-13.16) (-5.83)

QNL 4.5801 27.4776 8.4721

 (6.51) (8.83) (7.13)

DPNL -1.6072 -4.7611 3.0435

 (-2.07) (-4.48) (3.33)

PCG 0.0425 0.0255 -0.0201

 (3.20) (0.46) (-0.36)

RID(-1) 0.6897 -0.0770 0.3997

 (6.34) (-0.44) (1.77)

Coefficients of Polynomial Distributed Lag on PCG(-1):

 al = 0.0604 al = -0.0140 al = 0.0717

 a2 = 0.0612 a2 = -0.0093 a2 = 0.0737

 a3 = 0.0612 a3 = -0.0058 a3 = 0.0738

 a4 = 0.0607 a4 = -0.0033 a4 = 0.0723

 a5 = 0.0595 a5 = -0.0018 a5 = 0.0695

 a6 = 0.0579 a6 = -0.0012 a6 = 0.0654

 a7 = 0.0559 a7 = -0.0014 a7 = 0.0603

 a8 = 0.0534 a8 = -0.0023 a8 = 0.0543

 a9 = 0.0507 a9 = -0.0038 a9 = 0.0477

 a10 = 0.0477 a10 = -0.0058 a10 = 0.0406

 all = 0.0445 all = -0.0083 all = 0.0331

 a12 = 0.0413 al2 = -0.0110 a12 = 0.0256

 a13 = 0.0380 a13 = -0.0141 a13 = 0.0181

 a14 = 0.0347 a14 = -0.0172 a14 = 0.0109

 a15 = 0.0314 a15 = -0.0204 a15 = 0.0041

 a16 = 0.0283 a16 = -0.0235 a16 = -0.0020

 a17 = 0.0255 a17 = -0.0265 a17 = -0.0073

 a18 = 0.0229 a18 = -0.0293 a18 = -0.0117

 al9 = 0.0206 al9 = -0.0317 al9 = -0.0149

 a20 = 0.0187 a20 = -0.0337 a20 = -0.0167

 a21 = 0.0173 a21 = -0.0352 a21 = -0.0170

 a22 = 0.0165 a22 = -0.0361 a22 = -0.0155

 a23 = 0.0162 a23 = -0.0363 a23 = -0.0122

 Sum 0.9245 -0.3719 0.6238

 (15.45) (-2.57) (6.94)

Adjusted R2 0.987 0.957 0.935

Std. Error 0.1093 0.5519 0.7798

D-W 1.51 1.17 0.26
-2

-9

- 69 -

RESPECIFICATION OF THE DEFICIT-INTEREST RATE MODEL

The results in the previous section indicate that the 

original Feldstein-Eckstein specification of this interestrate determination equation needs to be changed for the sample

1965 QI - 1983 QII. This is done in this section, except 

that variables representing the Federal debt or deficit are 

omitted. These variables are added in Section III to test for

their possible effect on the interest rate. 

In respecifying the equation several changes are made. 

These changes were developed by experimenting with alternative 

specifications of equation (3). First, QNL is replaced by

XNL, the logarithm of real GNP per capita. Since real GNP is

a broader measure of output, it should reflect better the 

total effects of output upon interest rates. This variable 

comes in the equation as XNLA, which is defined as: 

XNLA = ( Σ i=0XNL(i))/3 (7)

Also, RID(-1) is replaced by RIDSL, which is

RIDSL = ( Σ i=-2RIDS(i))/8 (8)

where RIDS is the absolute value of RID.

RIDSL is a distributed lag on the absolute value of changes in 

the interest rate and is a better measure than RID(-1) of volatility in financial markets. The previous section showed that 

RID(-1) performs poorly and a better variable is needed.

In addition, the distributed lag using the current value of

PCG and a polynomial lag on PCG(-1) is replaced by a Pascal lag

on the current and lagged values, which captures the lag pattern

more concisely. In this paper a Pascal lag of a given order and

average lag is computed by calculating the first 21 lag coefficients for that order and average, then normalizing them so they

sum to unity and applying them to the current and lagged values

of the variable. In the following tables PCG04 and PCG08 are

Pascal lags on PCG of second and third orders respectively with

average lags of 4 and 8 quarters respectively. In the previous

section the average lag in equation (4) in the original sample

1954 QI - 1969 QII was over 8 quarters. However the negative

signs on the lags in the 1965 QI - 1983 QII sample suggest that

in that sample the average lag should be much shorter. As shown

below, the four-quarter average lag works well.
- 70 -

A final change is that HPNL is lagged two quarters. This 

two-quarter lag is consistent with the lag back two quarters of 

XNL, and the two-quarter lag of the two-year average of RIDS.

Estimates of the interest-rate equation respecified in 

this manner are presented in Tables 2 and 3. Included is an 

equation using the after-tax interest rate RIT defined as

RI(1-T), where T is the average marginal tax rate on interest 

income. Data for T were kindly provided by Vito Tanzi. These 

data are available only through 1981, so equation (12) stops 

at that point. 
- 71 -

 Table 2

 Final Specification of the Interest-Rate Equation

Equation Number 9 10 11 12

Dependent Variable RI RI RI RI

Sample 1965QI- 1965QI- 1965QI- 1965QI-

 1983QII 1983QII 1983QII 1981QIV

Estimation Method OLS ML Weighted ML Weighted ML

Independent Variables:

Constant -164.626 -259.860 -177.408 -93.1944

 (-3.94) (-3.94) (-3.06) (-1.82)

 HPNL(-2) -17.1459 -25.4711 -18.4304 -10.0429

 (-4.96) (-4.68) (-3.72) (-2.26)

XNLA 8.5508 10.1366 9.1457 5.4986

 (8.00) (5.11) (5.21) (3.38)

PCG04 0.4162 0.4493 0.4583 0.3136

 (9.65) (5.68) (6.39) (5.01)

RIDSL 5.0242 3.2855 3.4422 1.2472

 (10.72) (4.45) (4.65) (1.83)

Adjusted R2 0.974 0.870 0.991 0.977

Std. Error 0.4321 0.3643 0.7494 0.4922 

D-W 0.98 1.81 1.77 1.80

ρ ---- 0.6379 0.6047 0.7846
- 72 -

Table 3

Alternative Specifications of the Interest-Rate Equation

Equation Number 13 14 15

Dependent Variable RI RI RI

Sample 1965QI-1983QII 1965QI-1983QII 1965QI-1983QII

Estimation Method Weighted ML Weighted ML Weighted ML

Independent Variables:

Constant -172.251 -181.040 -77.9902

 (-2.86) (-3.26) (-0.91)

HPNL -12.2172

 (-1.63)

HPNL(-1) 10.2937

 (1.15)

HPNL(-2) -17.9934 -16.9534 -10.0458

 (-3.48) (-2.26) (-1.29)

XNLA 9.4869 8.2218

 (5.62) (2.25)

XNL 4.0470

 (0.98)

XNL(-1) 0.8672

 (0.18)

XNL(-2) 4.1764

 (1.01)

 PCG04 0.4559 0.4070

 (5.96) (5.87)

 PCG08 0.6940

 (4.10)

RIDSL 3.4982 3.9432 0.2344

 (4.58) (5.96) (0.17)

Adjusted R2 0.991 0.994 0.920

Std. Error 0.7594 0.7492 0.8008

D-W 1.76 1.82 1.82

ρ 0.6015 0.5005 0.9030
- 73 -

Equation (9) is the respecified equation estimated using 

ordinary least squares. The low Durbin-Watson statistic indicates serial correlation, so the equation is reestimated as 

equation (10) by full maximum likelihood with a first-order

serial correlation correction. However in addition to serial 

correlation, there is reason to believe that the error term in 

this equation is heteroscedastic. Specifically, when volatility 

in financial markets as measured by RIDSL is higher, there will 

probably be more variability in RI for given values of the 

independent variables. To test for this,5/ RIDSL was put

in ascending order and the rho-transformed variables from 

equation (10) were reordered correspondingly. The reordered 

sample of 74 observations was broken into three subsamples of

28, 18, and 28 observations, and the ratio of the residual

sums of squares from the last and first subsamples was computed. 

The result was 6.43, which when compared with an F distribution 

with 23 and 23 degrees of freedom leads to rejection of the 

null hypothesis at the usual levels of significance. 

In correcting for this heteroscedasticity, it was assumed 

that the variance of the disturbance in the equation was 

proportional to RIDSL. Accordingly, the equation was respecified 

by dividing all variables by the square root of RIDSL, and the 

resulting equation was estimated by maximum likelihood with 

the first-order serial correlation correction. The resulting 

estimates, termed weighted maximum likelihood estimates, are in 

equation (11). Using equation (11) and the same procedure as

in the previous paragraph, the statistic for testing for heteroscedasticity is reduced to 1.87, which is no longer significant. 

On balance the estimates in equations (9), (10), and (11) 

are relatively similar despite the different estimation techniques, which shows that this particular equation is robust

and captures a strong empirical regularity in the data. Equation (11) is the best equation. All the variables are highly 

significant. The coefficient on PCG04 is significantly 

different from unity, indicating that changes in inflation do 

not change RI to the same degree. As discussed before, this 

result has been found in other work. 

Table 3 contains estimates of variants of equation (11). 

This table shows that the lags on XNL are collinear, and they 

need to be weighted together. Also, the substitution of PCG08 

for PCG04 makes its coefficient not significantly different 

from unity, but the quality of the other coefficients deteriorates sharply.

 

5/ This test relies upon the work in Goldfeld and Quandt (1965). 

See also Theil (1971).
- 74 -

Finally, in equation (12) RIT is substituted for RI. The 

result is similar to equation (11), although the absolute values 

of the coefficients tend to fall. As hypothesized in Section I, 

the coefficient on PCG04 falls between equations (11) and (12).

EMPIRICAL RESULTS

In this section measures of the Federal deficit or debt 

are added to equation (11) to test whether they have any 

discernible effect on interest rates. The first measure added 

is DPNL as defined in the first section. Also tried is FPNL, 

which is the first difference in DPNL, that is, DPNL-DPNL(-1). 

And finally the variable SPN is added, which is the real per 

capita Federal surplus from the National Income and Product 

Accounts multiplied by 1,000,000. 

Tables 4, 5, and 6 contain estimates of equation (11) 

including various lags on these variables. Table 4 contains 

the equations with lags on DPNL. Table 5 contains lags on 

FPNL, and Table 6 contains lags on SPN. The variables DPNL04, 

FPNL04, and SPN04 are second-order Pascal lags on DPNL, FPNL, 

and SPN, respectively, with average lag of 4 quarters. 
- 75 -

 Table 4

 Estimates of the Before-Tax Interest-Rate

 Equation including DPNL

Equation Number 16 17 18 19

Dependent Variable RI RI RI RI

Sample 1965QI- 1965QI- 1965QI 1965QI-

 1983QII 1983QII 1983QII 1983QII

Estimation Method Weighted ML Weighted ML Weighted-ML Weighted ML

Independent Variables:

Constant -231.558 -206.309 -212.768 -147.344

 (-3.34) (-2.86) (-2.66) (-2.04)

HPNL(-2) -23.4899 -20.8375 -21.3883 -15.9987

 (-3.95) (-3.18) (-3.15) (-2.67)

 XLNA 11.1883 9.6731 9.9906 8.5872

 (5.86) (4.68) (4.53) (4.65)

 PCG04 0.3737 0.4218 0.4203 0.4773

 (5.50) (5.33) (4.83) (6.00)

 RIDSL 4.3550 3.9420 3.3991 3.7550

 (7.16) (5.55) (4.46) (4.95)

 DPNL -3.6217 -1.9624 -0.7205

 (-1.29) (-0.97) (-0.67)

DPNL(-1) -0.3550 -0.0027

 (-0.07) (-0.00)

DPNL(-2) 0.7152 1.5626

 (0.14) (0.77)

DPNL(-3) -1.2164

 (-0.23)

DPNL(-4) 4.0273

 (1.38)

 DPNL04 0.6597

 (0.59)

Adjusted R2 0.997 0.994 0.992 0.992

Std. Error 0.7399 0.7609 0.7529 0.7536

D-W 1.71 1.73 1.76 1.76

ρ 0.3366 0.4796 0.5823 0.5750
-76

 Table 5

 Estimates of the Before-Tax Interest-Rate

 Equation including FPNL

Equation Number 20 21 22 23

Dependent Variable RI RI RI RI

Sample 1965QI- 1965QI- 1965QI 1965QI-

 1983QII 1983QII 1983QII 1983QII

Estimation Method Weighted ML Weighted ML Weighted-ML Weighted ML

Independent Variables:

Constant -204.580 -200.159 -179.147 -215.429

 (-4.66) (-4.70) (-3.27) (-4.70)

 HPNL(-2) -21.1320 -20.5627 -18.5438 -22.7910

 (-5.56) (-5.61) (-3.96) (-5.58)

 XNLA 10.3865 9.8875 9.0881 12.2203

 (6.99) (7.91) (5.59) (7.19)

 PCG04 0.4005 0.4150 0.4494 0.3633

 (7.19) (8.57) (6.80) (6.51)

RIDSL 4.5331 4.5981 3.7808 3.9136

 (8.51) (9.11) (5.52) (7.18)

FPNL -3.5331 -5.4870 -1.4385 

 (-1.19) (-2.42) (-0.78) 

.FPNL(-1) -3.8382 -0.8981 

 (-1.27) (-0.43) 

 FPHL(-2) -2.5341 -5.3350 

 (-0.79) (-2.28) 

FPNL(-3) -4.2210 

 (-1.34) 

 FPNL(-4) 0.7049 

 (0.22) 

 FPNL04 -20.1086

 (-3.15)

Adjusted R2 0.997 0.997 0.993 0.996

Std. Error 0.7411 0.7404 0.7532 0.7198

D-W 1.71 1.75 1.75 1.71

ρ 0.3409 0.3176 0.5449 0.3884
- 77 -

 Table 6

 Estimates of the Before-Tax Interest-Rate

 Equation including SPN

Equation Number 24 25 26 27

Dependent Variable RI RI RI RI

Sample 1965QI- 1965QI- 1965QI 1965QI-

 1983QII 1983QII 1983QII 1983QII

Estimation Method Weighted ML Weighted ML Weighted-ML Weighted ML

Independent Variables:

Constant -188.312 -194.676 -190.717 -191.487

 (-4.57) (-4.44) (-3.93) (-4.87)

HPNL(-2) -20.0534 -20.1671 -19.5289 -20.9441

 (-5.68) (-5.36) (-4.70) (-6.06)

 XNLA 10.8848 9.9696 9.2255 12.3592

 (8.16) (7.58) (6.56) (8.35)

 PCG04 0.4001 0.4309 0.4557 0.3767

 (7.89) (8.35) (7.96) (7.84)

RIDSL 4.8487 4.7815 4.3831 4.5291

 (9.62) (8.90) (7.25) (9.38)

 SPN 0.1007 0.1114 0.1727 

 (1.07) (1.19) (2.09) 

SPN(-1) 0.0611 0.0645 

 (0.56) (0.60) 

SPN(-2) 0.0350 0.1178 

 (0.32) (1.23) 

SPN(-3) 0.0778 

 (0.76) 

SPN(-4) 0.1136 

 (1.22) 

SPN04 0.5260

 (4.00)

Adjusted R2 0.997 0.997 0.995 0.997

Std. Error 0.7283 0.7356 0.7397 0.7020

D-W 1.73 1.73 1.74 1.73

ρ 0.3046 0.3518 0.4493 0.3287
- 78 -

In order for the level of the Federal debt or the change 

in the debt to raise interest rates, the sign on the debt terms 

in the equations in Tables 4 and 5 should be positive. However 

all the coefficients either have a negative sign or are positive 

and insignificant. In the case of FPNL and FPNL(-2) in equation (21) and FPNL04 in equation (23), the sign is negative

and significant, indicating that an increase in the debt is 

correlated with lower interest rates. In addition, the other 

coefficients in the equations remain near to those in equation 

(11). Hence the debt variables do not contribute to equation 

(11), nor do they suggest that a change in specification is 

needed.

The same conclusions hold with regard to lags on SPN in 

Table 6. If deficits raise interest rates, the sign on such 

lags should be negative. However all the signs are positive, 

and SPN04 is significant. Again the other coefficients change 

little, so this deficit variable contributes nothing to the 

equation.

The equations in Tables 4, 5, and 6 are presented in Tables 

7, 8, and 9 with the dependent variable changed to the after-tax 

interest rate RIT, and with the sample 1965 QI - 1981 QIV. The 

results are similar to those using the before-tax interest 

rate. Lags on DPNL and FPNL have negative or positive and 

insignificant coefficients. Again FPNL04 is significant negative. All the signs for SPN are positive. Again SPN04 is 

positive and significant.
-79

 Table 7

 Estimates of the After-Tax Interest-Rate

 Equation including DPNL

Equation Number 28 29 30 31

Dependent Variable RIT RIT RIT RIT

Sample 1965QI- 1965QI- 1965QI 1965QI-

 1981QIV 1981QIV 1981QIV 1981QIV

Estimation Method Weighted ML Weighted ML Weighted-ML Weighted ML

Independent Variables:

Constant -112.530 -102.994 -106.143 -91.6961

 (-2.10) (-1.73) (-1.80) (-1.58)

HPNL(-2) -11.7598 -10.6430 -10.9254 9.9487

 (-2.54) (-2.10) (-2.17) (-2.05)

 XNLA 6.2653 5.4962 5.6262 5.4978

 (4.26) (3.32) (3.38) (3.31)

PCG04 0.2173 0.2639 0.2673 0.3162

 (4.24) (3.98) (4.02) (4.50)

RIDSL 2.8275 1.9298 1.7185 1.2451

 (6.17) (3.21) (2.82) (1.76)

DPNL -2.2385 -0.5956 -0.6390 

 (-1.18) (-0.45) (-0.80) 

DPNL(-1) -0.4737 -0.5282 

 (-0.14) (-0.29) 

DPNL(-2) 0.1819 0.5621 

 (0.05) (0.42) 

 DPNL(-3) -0.3647 

 (-0.10) 

DPNL(-4) 2.4121 

 (1.21) 

DPNL04 0.0796

 (0.07)

Adjusted R2 0.996 0.989 0.987 0.976

Std. Error 0.4979 0.5043 0.4961 0.4961

D-W 1.67 1.74 1.76 1.80

ρ 0.3961 0.6472 0.6874 0.7868
- 80 -

 Table 8

 Estimates of the After-Tax Interest-Rate

 Equation including FPNL

Equation Number 32 33 34 35

Dependent Variable RIT RIT RIT RIT

Sample 1965QI- 1965QI- 1965QI 1965QI-

 1981QIV 1981QIV 1981QIV 1981QIV

Estimation Method Weighted ML Weighted ML Weighted-ML Weighted ML

Independent Variables:

Constant -83.0189 -76.8514 -93.5644 -94.5330

 (-2.35) (-2.18) (-1.78) (-2.66)

 HPNL(-2) -9.2966 -8.5467 -10.0835 -10.7367

 (-2.99) (-2.79) (-2.21) (-3.36)

XNLA 5.6640 5.0705 5.5245 6.8686

 (4.81) (4.98) (3.31) (5.39)

 PCG04 0.2374 0.2564 0.3151 0.2165

 (5.57) (6.70) (4.95) (5.28)

 RIDSL 2.9492 2.9507 1.2070 2.5639

 (7.06) (7.11) (1.74) (6.27)

FPNL -1.6403 -2.9270 0.0875 

 (-0.80) (-1.83) (0.08) 

FPNL(-1) -2.1895 -0.7387 

 (-1.09) (-0.54-) 

FPNL(-2) -2.3181 -3.2890 

 (-1.08) (-1.97) 

FPHL(-3) -2.0874 

 (-0.99) 

FPHL(-4) -0.6757 

 (-0.31) 

 FPNL04 -14.0588

 (-3.09)

Adjusted R

2 0.996 0.996 0.976 0.996

Std. Error 0.4998 0.4973 0.4960 0.4766

D-W 1.68 1.71 1.80 1.69

ρ 0.4036 0.4142 0.7906 0.4344
- 81 -

 Table 9

 Estimates of the After-Tax Interest-Rate

 Equation including SPN

Equation Number 36 37 38 39

Dependent Variable RIT RIT RIT RIT

Sample 1965QI- 1965QI- 1965QI 1965QI-

 1981QIV 1981QIV 1981QIV 1981QIV

Estimation Method Weighted ML Weighted ML Weighted-ML Weighted ML

Independent Variables:

Constant -62.1310 -66.6548 -70.5344 -69.4095

 (-1.99) (-1.89) (-1.75) (-2.28)

 HPNL(-2) -7.6418 -7.6734 -7.8693 -8.6371

 (-2.82) (-2.51) (-2.25) (-3.22)

XNLA 5.6932 4.9288 4.6624 6.6492

 (5.71) (4.74) (3.94) (6.09)

 PCG04 0.2409 0.2700 0.2880 0.2323

 (6.48) (6.78) (6.13) (6.61)

RIDSL 3.1964 3.0000 2.5197 2.9457

 (8.42) (6.98) (4.96) (7.96)

SPN 0.0601 0.0648 0.0797 

 (0.93) (1.00) (1.31) 

SPN(-1) 0.0131 0.0234 

 (0.18) (0.33) 

SPN(-2) 0.0214 0.0806 

 (0.29) (1.22) 

SPN(-3) 0.0818 

 (1.20) 

SPN(-4) 0.0749 

 (1.18) 

SPN04 0.3528

 (3.71)

Adjusted R2 0.997 0.996 0.993 0.997

Std. Error 0.4889 0.4982 0.4963 0.4690

D-W 1.71 1.71 1.73 1.71

ρ 0.3418 0.4282 0.5629 0.3759
- 82 -

CONCLUSIONS

This paper examined the empirical evidence of an association between changes in the Federal debt or deficit and real 

interest rates. The approach taken was to estimate an interestrate equation without the debt or deficit measures, and then 

add them in to test for their statistical significance. 

The interest-rate equation was based upon equation (10) 

in Feldstein and Eckstein (1970). The first step was to 

replicate this equation as nearly as feasible for the original

sample period, and extend it for the sample 1965 QI - 1983 

QII. The results indicated that this type of equation could 

be used for the latter sample, but that it needed respecification. 

The respecified equation contained more lags than the original. 

Measures of debt and the deficit were then added to this 

equation. Such measures were either of the wrong sign, or 

of the correct sign but insignificant. Moreover the other 

coefficients were little affected. On the basis of these tests, 

it would appear that over the sample examined high Federal 

deficits have had at most a negligible effect in raising real 

interest rates. 
- 83 -

REFERENCES

Darby, M. R., 1975, "The Financial and Tax Effects of Monetary 

Policy on Interest Rates," Economic Inquiry, June. 

Feldstein, M., 1976, "Inflation, Income Taxes, and the Rate of 

Interest: A Theoretical Analysis," The American Economic Review,

December. 

Feldstein, M., and G. Chamberlain, 1973, "Multimarket Expectations 

and the Rate of Interest," Journal of Money, Credit, and Banking,

November.

Feldstein, M., and O. Eckstein, 1970, "The Fundamental Determinants of the Interest Rate," The Review of Economics and Statistics, November.

Fisher, I., 1930, The Theory of Interest, The Macmillan Company, 

New York.

Goldfeld, S. M., and R. E. Quandt, 1965, "Some Tests for Homoscedasticity," Journal of the American Statistical Association, June.

Pearce, D. K., 1979, "Comparing Survey and Rational Measures of 

Expected Inflation: Forecast Performance and Interest Rate

Effects," Journal of Money, Credit and Banking, November.

Peek, J., 1982, "Interest Rates, Income Taxes, and Anticipated 

Inflation," The American Economic Review, December.

Sinai, A., and P. Rathjens, 1983, "Deficits, Interest Rates, and

the Economy," Data Resources U.S. Review, June.

Summers, L. H., 1983, "The Nonadjustment of Nominal Interest 

Rates: A Study of the Fisher Effect," in J. Tobin, ed., Macroeconomics, Prices, and Quantities, The Brookings Institution, 

Washington, D.C.

Tanzi, V., 1980, "Inflationary Expectations, Economic Activity, 

Taxes, and Interest Rates," The American Economic Review, March.

Theil, H., 1971, Principals of Econometrics, John Wiley & Sons, 

Inc., New York.

Wood, J. H., 1981, "Interest Rates and Inflation," Economic Perspectives, May/June.

Yohe, W. P., and D. S. Karnosky, 1969, "Interest Rates and Price 

Level Changes, 1952-69," Federal Reserve Bank of St. Louis Review,

December.

*U.S. GOVERNMENT PRINTING OFFICE : 1984 0-421-267/3435