Fiscal Policy and the Term Structure: Evidence from the Case of Italy in the EMS and the EMU Periods
Carlo A. Favero
Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. 5793
We study the relationship between the term structure of interest rates and fiscal policy by considering the Italian case. Empirical analysis has been so far rather inconclusive on this important topic. We abscribe such evidence to three problems: identification, regime-switching and maturity effects. All these aspects are particularly relevant to the Italian case. We propose a parsimonious model with three factors to represent the whole yield curve, and we consider yield differentials between Italian and German Government bonds. To take into account the possibility of regime-switching, we explicitly include a hidden two-state Markov chain that represents market expectations. The model is estimated using Bayesian econometric techniques. We find that government debt and its evolution significantly influence the yield of government bonds, that such effects are maturity dependent and regime-dependent. Hence when investigating the effect of fiscal policy on the term-structure it is of crucial importance to allow for multiple regimes in the estimation.
Number of Pages in PDF File: 41
Keywords: Fiscal policy, term structure, regime-switching, Bayesian estimation
JEL Classification: E0, G0working papers series
Date posted: October 10, 2006
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