Public Debt and the Slope of the Term Structure

Fisher College of Business Working Paper No. 2018-03-23

Charles A. Dice Center Working Paper No. 2018-23

55 Pages Posted: 14 Dec 2018 Last revised: 7 Mar 2019

See all articles by Thien Tung Nguyen

Thien Tung Nguyen

Ohio State University (OSU) - Department of Finance

Date Written: November 15, 2018

Abstract

The maturity-weighted public debt-to-GDP ratio predicts negatively one- to five-year cumulative nominal consumption growth. Moreover, a higher debt-to-GDP ratio is associated with higher yield spreads, controlling for output gap and inflation. I examine these facts in a New Keynesian DSGE model in which growth and inflation are endogenous. In this model, high government debt forecasts low growth and deflation, making bonds attractive assets in high debt states. Furthermore, due to mean-reversions of fundamental processes that drive the economy, longer-term bonds are better hedges than shorter-term ones, resulting in increases in the slope of the term structure at times of high public debt and hence the empirical regularities seen in the data. My model can also explain several other puzzling phenomena, including the bond premium puzzle, the bond yield volatility puzzle, the failure of the expectations hypothesis, and the ability of a linear combination of the forward rates and the forward spread to forecast excess bond returns.

Keywords: Government Debt, Fiscal Policy, Term Structure of Interest Rates, Endogenous Growth Risk

JEL Classification: E43, E44, E62, G12, G18, H32

Suggested Citation

Nguyen, Thien Tung, Public Debt and the Slope of the Term Structure (November 15, 2018). Fisher College of Business Working Paper No. 2018-03-23. Available at SSRN: https://ssrn.com/abstract=3285197 or http://dx.doi.org/10.2139/ssrn.3285197

Thien Tung Nguyen (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

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