Fiscal Policy and Interest Rates: The Role of Financial and Economic Integration

Peter Claeys, Rosina Moreno and Jordi Suriñach

A chapter in Progress in Spatial Analysis, 2010, pp 311-336 from Springer

Abstract: Abstract A government running a deficit needs to turn to financial markets to place this additional public debt. Newly issued public bonds compete for financing with bonds issued by private agents. The additional demand created by the fiscal expansion pushes up interest rates, and eventually crowds out private investment. Not all economists agree that consolidating public finances would immediately reduce pressure on interest rates, however. Despite a vast literature testing crowding out, there is actually surprisingly little robust empirical support for this hypothesis.1 Interest rates are insulated from fiscal policy under two alternative conditions. The first explanation for a zero impact of deficits on aggregate macroeconomic variables is that economic agents anticipate paying down currently high deficits with higher taxes in the future. Under Ricardian Equivalence, private saving fully offsets the effect of higher public consumption (for a given level of taxation). Few economists would consider the assumptions underlying the Ricardian Equivalence null as realistic, however. More elaborate macroeconomic models that depart from the baseline Ricardian assumption easily find real economic effects of fiscal policy. There is by now also a large body of empirical evidence that clearly refutes the Ricardian hypothesis (Blanchard and Perotti 2002).

Keywords: Interest Rate; Financial Market; Fiscal Policy; Spillover Effect; Public Debt (search for similar items in EconPapers)
Date: 2010
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Working Paper: Fiscal policy and interest rates: the role of financial and economic integration (2008)
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DOI: 10.1007/978-3-642-03326-1_15

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