Governmental Budget Deficits and Interest Rates: A Post Keynesian Approach to the Ricardian Equivalence Proposition in Greece

Abstract

This paper revisits the issue of the Ricardian Equivalence Hypothesis (REH), as since its reemergence, its theoretically underlying premises have been called into question. Yet, severe criticism raised by its opponents concerning the efficacy of government actions has further challenged the need for empirical analysis. In the traditionally Keynesian approach, the majority of the research work has ignored issues pertinent to cointegration and/or the stationarity-exogeneity features of the data, thus offering rather vitiated results. In this paper, the author suggests that as long as a single cointegrating vector exists, the Phillips-Hansen OLS estimator can be safely adopted, as it is asymptotically equivalent to full-information system methods. The main result sharply contradicts conventional priors of REH, as budget deficits strongly affect the pattern of interest rates. However, any unidirectional short-run causality link between these variables has not been established. Nevertheless, rigorous testing of the model, in terms of binding restrictions occasionally introduces sensitivity in certain findings. As a policy exercise, the paper tries to identify the determinants of the long-term interest rates, crucial in this study. The evidence demonstrates a decisive role for macroeconomic policy in shaping interest rates suggesting that national, rather than the international factors or the structure of the economy per se, seem to be more important in explaining interest rates behavior in Greece.

Keywords: Budget Deficits, Interest Rates, Cointegration, Exogeneity, Granger-Causality

JEL Classification: C32, E62, G18