Government Spending and Interest Rates

Abstract

Most macroeconomic models imply that increases in government spending cause interest rates to rise, but empirical evidence from the U.S. generally fails to support this prediction. We propose a novel explanation for how government spending can have a muted or negative temporary effect on interest rates: the increased supply of loans associated with government spending is offset by an increase in the demand for loans due to higher aggregate income. We demonstrate this mechanism theoretically and provide evidence consistent with the model's predictions.

Keywords: Interest Rates, Fiscal Policy, Aggregate Demand,

JEL Classification: E21, E41, E42, E43, E44, E62, F34