EIFM Seminar 3 – week commencing Oct 25th 2021

Question 1: “Deficit financing by the government always leads to higher interest rate.” Do you agree with this statement? Read the introduction of the paper below titled “Government Budget Deficits and Interest Rates: The Evidence since 1971, Using Alternative Deficit Measures” by Khan Zahid before answering. Explain your answer using the asset market approach.

Does deficit financing by the government lead to higher interest rates? The empirical evidence on this point has been rather inconclusive. On the one hand, we see that treasury issues of securities depress their prices and increase their yields in the markets. Hoelscher [13], and Deleuw and Holloway [6] have found evidence linking deficits to interest rates. On the other hand, analytical studies of this issue have failed to provide conclusive evidence linking real interest rates to government budget deficit. See, for example, Dwyer [8], Plosser [19], Hoelscher [12], Mascaro and Meltzer [17], Makin [16], Motley [18], Dewald [7], and Evans [11]. In this paper we study the empirical linkage between deficits and interest rates for the period since 1971. In recent periods both deficits and interest rates have increased significantly compared to historical levels, and, we want to see if the long term evidence concerning no linkage between deficits and real interest rates also applies to this more recent period, bringing into sharper focus a couple of issues not adequately analyzed in the previous literature. Specifically, we deal with the issues of measurement of government budget deficits, and cyclical variations in the deficit interest rates. Traditional theories suggest two possible ways that deficits can affect real interest rates. First, there is the Keynesian IS-LM analysis, where this linkage works through the goods and services market. Furthermore, if the public treats government securities as net wealth then would increase aggregate demand by increasing private consumption.’ Second, there is the assets markets approach, where the supply and demand for government securities determine its market yield. A deficit, by increasing the supply of government securities, ceteris paribus, reduces price and raises market interest rates. Recent theories have suggested a number of reasons why the deficit interest rate linkage may not exist. Barro [1] suggests (termed the Ricardian Equivalence Theorem in the literature) that, if the public is fully aware of the future tax implications of debt financing, and intergenerational transfers are a major motive for savings, then any increase in government debt would be matched by an equal increase in current savings, with no impact on domestic interest rates. The second reason suggested is if the purchase of government securities by the Federal exactly the increase in supply of government securities. Finally, Darby [5] suggests open economy with a very high degree of international capital mobility, an increase debt would be matched by an equal increase in foreign capital inflows, without on domestic interest rates.

A: Reasons to agree:

1. The large federal deficits require the Treasury to issue more bonds; thus the supply of bonds increases. The supply curve, Bs, shifts to the right and the equilibrium interest rate rises.

Reasons to disagree:

1. Some economists believe that when the Treasury issues more bonds, the demand for bonds increases because the issue of bonds increases the public’s wealth. If this is the case, the demand curve, Bd, will also shift to the right, and it is no longer clear that the equilibrium interest rate will rise. Thus there is some potential ambiguity in the answer to this question.

a. Barro suggests that, if the public is aware of the full implications of budget financing, and intergenerational transfers are major motives for savings, then any increase in the supply of government bonds will be matched by an equal increase in the demand for bonds, causing no change to interest rates.

b. If the issues of government bonds are exactly matched by the purchases of government bonds by the US Federal Reserves, then there would be no change to interest rates.

c. In a small open economy with a very high degree of international capital mobility, an increase in the issues of government bonds could attract an equal amount of foreign capital inflow, causing no change to domestic interest rates.

Question 2: M1 money growth in the U.S. was about 16% in 2008, 7% in 2009, and 9% in 2010. Over the same time period, the yield on 3-month Treasury bills fell from almost 3% to close to 0%. Given these high rates of money growth, why did interest rates fall, rather than increase? What does this say about the income, price-level, and expected-inflation effects?

A: With unusually high rates of money growth, this should lead to higher expected inflation, a jump in the overall price level, and stronger economic growth. These factors should all result in interest rates rising over time, notwithstanding the liquidity effect. However, in the period from 2008 to 2010, unemployment remained high, economic growth was weak, and if anything, policymakers were worried about deflation (a decrease in the price level) rather than any inflationary effects from the money growth. In other words, the income, price-level, and expected inflation effects of the unusually high money growth conditions were very small relative to the liquidity effect. This is similar to case (a) shown in Figure 11.

Question 3: Read the below excerpt of the article “The impact of the COVID-19 crisis on the equilibrium interest rate” by Gavin Goy and Jan Willem van den End. Answer the following two-part question.

a. If multiple waves of the COVID-19 virus would demand the lockdowns to continue for longer, what would happen to equilibrium interest rate?

A: The precautionary saving and the propensity to save will increase. These will cause the demand for bonds to increase and the interest rates to fall. In addition, the aggregate demand will fall unboundedly, decreasing the investment demand of private sector. The supply of corporate bonds will fall, causing an increase in bond price and a fall in interest rates.

b. How might the fiscal measures taken by governments affect equilibrium interest rate?

A: The equilibrium interest rate might remain the same or rise. The fiscal measures such as furlong scheme are designed to stabilise income for households and provide support to firms. They could reduce the contraction in output and provide incentives for individuals to continue spending rather than increasing precautionary saving and the propensity to save. This could cause the demand for bonds to not increase and the interest rate to stay at pre-pandemic level rather than decreasing.

In addition, the fiscal measures are largely financed by increased government borrowing. This increase in the supply of government bonds could be greater than the increase in the demand for bonds, therefore increasing interest rates.

The COVID-19 crisis started as a supply side shock that morphed into a demand shock. High uncertainty and strict lockdown measures are increasingly weighing on the economy, leading to a rise in private savings in the short run. The fall in aggregate demand is, at least partly, compensated by higher government spending, as governments announced substantial fiscal policy measures. While changes in public savings can be seen as a mirror image of private savings in the short run, the effects of the COVID-19 outbreak on aggregate savings are less clear going forward.

Assuming that the COVID-19 crisis is a temporary shock that does not affect savings preferences in the long run, the pent-up demand will give rise to a higher interest rate once the crisis has been solved (given that the equilibrium interest rate is the relative price of future goods over today’s goods). Yet, given the budgetary restrictions in the euro area, budgetary positions will need to be improved at some point, so that the provided fiscal stimulus will be temporary. This reduces the room for a permanent reduction in public savings.

If multiple waves of the COVID-19 virus would demand the lockdowns to continue for longer, the recession might become more prolonged, as opposed to a V-shaped recovery. In this case, the marginal propensity to consume may fall, as higher unemployment risk may further increase preferences for precautionary savings. In this context, Jordà et al. (2020) find suggestive evidence that a shift to precautionary savings is a typical feature of pandemic periods. Such an increase in risk aversion – similar to the one observed after the Global Crisis – will further depress the equilibrium interest rate. As a result, the economy moves towards a new equilibrium (or balanced growth path) with higher uncertainty and lower economic growth.

The lockdown of economies creates conditions in which private sector demand may fall unboundedly. The fiscal measures taken by governments aim to prevent this, by stabilising incomes of households and providing support to firms in the short run. By mitigating the contraction in output, the fiscal policy measures can also affect the equilibrium interest rate to the extent to which they prevent hysteresis, i.e. the transition to the aforementioned new equilibrium with lower potential growth. This argument is akin to the one made by Summers and Rachel (2019), yet note that the fiscal measures will only prevent a further decline in the equilibrium rate, but not raise potential growth above levels seen before the outbreak of COVID-19.

The reason is that the current fiscal expansion will be unlikely to revert the downward trend in investment demand, if it aims at supporting existing economic activities rather than stimulating new investments, R&D or structural reforms. Yet another side effect of higher public spending and borrowing in the longer term might be potential crowding out effects of private investments, which will ultimately also weight on the equilibrium interest rate. Hence to bolster potential growth, it is important that public spending supports private investments and productivity by creating growth enhancing conditions, e.g. by spending on infrastructural projects that would elicit private activities. Along these lines, Krugman (2020) recently called for a permanent deficit financed increase in public investment, arguing that debt sustainability is not an issue as long as interest rates remain below the nominal growth rate.

The additional public spending due to the COVID-19 crisis will – by and large – be financed by increasing public debt. Germany, for instance, announced to increase debt issuance by an additional €156 billion this year (roughly 4% of its GDP), while for the Netherlands the range is between €45 and €65 billion. This outward-shift of the supply curve in the government bond market leads to an increase in bond yields (Figure 1) – a phenomenon already observed for some countries in anticipation of the announced fiscal measures.

If the increased supply of government bonds persists, it will have a positive effect on the equilibrium interest rate, to the extent that these bonds are considered safe (see e.g. Del Negro et al. 2017 and Caballero and Fahri 2019). The reason is that safe assets hold a convenience yield, which lowers the bond yield. The greater the supply of safe assets, the lower the convenience yield and hence the higher the equilibrium interest rate (conditional on the demand for safe assets).

Against the backdrop of a sharp drop in aggregate demand and the potentially increased precautionary savings, safe governments bonds provide a vehicle for the private sector to hold its increased savings. As a result, increased debt issuance prevents the equilibrium interest rate from falling unboundedly. In the current crisis, a coordinated European debt issuance (either corona bonds or ESM issuance) could contribute to meet the private sector preference for safe assets.

Figure 1 Supply and demand in sovereign bond markets

Source: extension by the authors of the stylized model of Summers and Rachel (2019)

Summers and Rachel (2019) already argued before the COVID-19 crisis that a rise in public debt will lift the equilibrium interest rate. According to their estimates, the increase in public debt-to-GDP ratio by 50 percentage points to 68% GDP in advanced economies since the 1980s has raised the natural rate by 1.5-2 percentage points, ceteris paribus.”