The recent resurgence of federal budget deficits has rekindled debates about the effects of government debt on interest rates. While the effects of government debt on the economy can operate through a number of different channels, many of the recent concerns about federal borrowing have focused on the potential interest rate effect. Higher interest rates caused by expanding government debt can reduce business investment spending, inhibit interest-sensitive household spending, and decrease the value of assets held by households, thus indirectly dampening spending. The magnitude of these potential adverse consequences depends on the degree to which federal debt actually raises interest rates. Despite a substantial body of empirical analysis, the answer based on the past two decades of economic research is mixed. While some studies suggest, at most, a small rise in interest rates when government debt increases, others either estimate much larger effects or find no effect.

Using a standard set of data for the United States and a simple economic framework, AEI’s Eric M. Engen and other experts reexamine the effect of federal government debt and interest rates. Using an economic model and empirical analysis to derive the effect of government debt on the real interest rate, they calculate that an increase in government debt equivalent to 1 percent of GDP--currently equal to about $110 billion--would increase the real interest rate by about two to three basis points.