Federal Government Debt and Interest Rates

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Summary

Past research on the effect of government debt on interest rates have found mixed results, from a large effect to none at all, depending on the approach used. Using a standard set of data and a simple analytical framework, the authors reconsider and add to empirical evidence on the effect of federal government debt on interest rates.

First, the effect of government debt on the real interest rates is analytically derived, and it is found that an increase in government debt equivalent to 1 percent of GDP would increase the real interest rate by two to three basis points.

The authors then do an empirical analysis in two parts: first, a variety of conventional reduced-form specifications linking forward-looking and current measures of interest rates and forward-looking and current measures of government debt and other variables are examined, and second, evidence using vector autoregression analysis is provided. In general, the results are consistent with what was predicted in the simple analytical calculation.

Eric M. Engen is a resident scholar, and R. Glenn Hubbard a visiting scholar, at AEI.

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