Fiscal Policy and the Term Structure of Interest Rates

37 Pages Posted: 5 Jan 2005

See all articles by Qiang Dai

Qiang Dai

University of North Carolina (UNC) at Chapel Hill - Finance Area

Thomas Philippon

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2004

Abstract

Macroeconomists want to understand the effects of fiscal policy on interest rates, while financial economists look for the factors that drive the dynamics of the yield curve. To shed light on both issues, we present an empirical macro-finance model that combines a no-arbitrage affine term structure model with a set of structural restrictions that allow us to identify fiscal policy shocks, and trace the effects of these shocks on the prices of bonds of different maturities. Compared to a standard VAR, this approach has the advantage of incorporating the information embedded in a large cross-section of bond prices. Moreover, the pricing equations provide new ways to assess the model's ability to capture risk preferences and expectations. Our results suggest that (i) government deficits affect long term interest rates: a one percentage point increase in the deficit to GDP ratio, lasting for 3 years, will eventually increase the 10-year rate by 40-50 basis points; (ii) this increase is partly due to higher expected spot rates, and partly due to higher risk premia on long term bonds; and (iii) the fiscal policy shocks account for up to 12% of the variance of forecast errors in bond yields.

Keywords: No-arbitrage, interest rates, yield curve, fiscal policy, public deficits

JEL Classification: E43, E44, E62, C32

Suggested Citation

Dai, Qiang and Philippon, Thomas, Fiscal Policy and the Term Structure of Interest Rates (December 2004). Available at SSRN: https://ssrn.com/abstract=640582 or http://dx.doi.org/10.2139/ssrn.640582

Qiang Dai

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-7182 (Phone)

Thomas Philippon (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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