Default Risk, Interest Differentials and Fiscal Policy: A New Look at Crowding Out

David Bowles, Holley Ulbrich and Myles Wallace
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David Bowles: BellSouth
Myles Wallace: Clemson University

Eastern Economic Journal, 1989, vol. 15, issue 3, 203-212

Abstract: The crowding out debate fails to incorporate the impact of expansionary policy on interest rates for private sector borrowing through changes in perceived default risk. In a modified IS-LM model with default risk dependent on the state of the economy, government borrowing has an indeterminate effect on interest rates for private borrowers; reduced default risk mitigates any crowding out effect. Testing the model with data from 1959-85 verifies a default risk effect for both monetary and fiscal policy. Expansionary policy reduces the spread between Baa corporate bonds and Treasury bonds of equal maturity.

Date: 1989
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