Some of the difficulties associated with empirical studies that attempt to estimate the relationship between deficits and interest rates are illuminated by focusing on the role played by expectations. Using a simple theoretical model of asset price determination with rational expectations, it is shown that a time-invariant relationship between the actual movements in interest rates and changes in the supply of government debt does not necessarily exist. Utilizing a rational expectations-efficient markets framework, the empirical evidence presented suggests (1) only previously unexpected changes in current or future government debt have a contemporaneous effect on interest rates, and (2) shifts in the stochastic process underlying the deficit complicate considerably the estimation of what in fact is unexpected at a moment in time.
All Science Journal Classification (ASJC) codes
- General Business, Management and Accounting
- Economics and Econometrics