How do governments respond to interest rates?

Franc Klaassen, Roel Beetsma and Joao Jalles

No 18257, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We explore the optimal and actual responses of fiscal policy to changes in the interest rate on newly-issued public debt (the “marginal interest rate†). We set up a simple theoretical framework with a government aiming to smooth public consumption over time. The distinctive feature is that the government issues debt of different maturities. This introduces a “valuation effect†that has received little attention so far: a rise in the marginal interest rate increases the rate of discounting and, thus, lowers the value of non-maturing debt, which relaxes the budget constraint, thereby inducing a fall in the primary balance. Still, the framework predicts that the total effect of a rise in the marginal interest rate is an increase in the primary balance. Estimates for developed countries suggest that a 1 percentage-point higher marginal interest rate leads, on average, to roughly a 1 percentage-point higher primary balance. These findings are consistent with governments smoothing the impact of changes in the marginal interest rate and exploiting the valuation effect. Finally, estimates suggest a role for the average (or “effective†) interest rate on outstanding debt.

JEL-codes: E4 E62 H6 (search for similar items in EconPapers)
Date: 2023-07
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