EXAMINING THE RELATIONSHIP BETWEEN AUSTRALIA’S BUDGET DEFICIT AND DOMESTIC INTEREST RATES
Project Topic Area: Budget deficits and interest rates
Class: ECON3007 Intermediate Econometrics
Date: May 31, 2013.
This paper examines the empirical relationship between Australia’s federal budget underlying cash balance and the real interbank rate. Results from the period 1976-2013 suggest xxxx
2. Theory & Research Review
3. Econometric Model
6. Model Testing
8. Model Critique
Budget deficits have been significantly rising in recent years1 as economies around the world struggle to reignite their economy and move towards growth. An important economic question arises from these circumstances, are these rising deficits hindering growth?
Orthodox economists argue deficits hinder growth, one such way is that a deficit puts upward pressure on interest rates. Following the 2008 Global Financial Crisis, orthodox economists pushed governments, particularly in the Eurozone, to reduce their budget deficits and move to a balanced budget in order to promote economic growth. Alternatively, Modern Monetary Theory (MMT) economists argued that governments should run deficits in order to promote growth.
This paper looks at Australia’s federal budget balance and its relationship with domestic interest rates. It extends the work of Yan and Brittle in Reconsidering The Link Between Fiscal Policy And Interest Rates In Australia by using time series data which occurs over a larger time frame. I will also recognise severe errors in my model and in previous models.2
The following sections of this paper are organized as follows. Section 2 will review the theoretical and empirical literature on the link between deficits and interest rates. Section 3 will present a simplified econometric model based on Brittle and Yan. Section 4 reviews the data used for analysis. section 5 will give estimates for a model. Section 6 will test the robustness of this model. Section 7 discusses policy implications. Section 8 is a self evaluation of my model.
2 Theory & Research Review
Neoclassical Theory follows that in order to finance a budget deficit a government has two options, tax or borrow. Choosing to borrow will increase the demand in the domestic money market and put upward pressure on the interest rate. While choosing to tax will reduce savings and the supply of funds for borrowing, putting upward pressure on interest rates.
MMT describes a relationship that a deficit will put downward pressure on interest rates. The theoretical underpinning for this is that sovereign nations with fiat currencies do not need to borrow to spend. Holding this to be true means a budget deficit injects more into the economy than it leaks out. This injection adds to the deposits of Exchange Settlement Accounts (ESA’s) at the RBA, putting downward pressure on the interbank rate, ceteris paribus. In reality this downward pressure would be diffused by the RBA through OMO.3 Professor Bill Mitchell summarises the real world relationship according to MMT , “You will appreciate clearly – there is no relationship.”
These conflicting idea are reflected in The Effects of Federal Budget Deficits on Interest Rates and the Composition of Domestic Output, in, The Great Fiscal Experiment (1991). The paper looks at 42 empirical papers, 17 of the papers presented a positive relationship between deficits and interest rate. Conversely, 19 modeled negative effects, and even 6 papers concluded with a mixed relationship.
Regarding the Australian economic system, very little empirical studies have been conducted. Comley et al. examined the relationship between the interest margin and government bond yields for the period 1985...
References: Hong, Y. and Brittle, S. 2010, Reconsidering The Link Between Fiscal Policy And Interest Rates In Australia, Treasury Working Paper 2010 — 04, Macroeconomic Policy Division, The Treasury, Canberra, Australia.
Barth, J. R. Iden, G. Russek, F. S. and Wohar, M. 1991, The Effects of Federal Budget Deficits on Interest Rates and the Composition of Domestic Output, in, The Great Fiscal Experiment, 69-142, Urban Institute Press, Washington D.C.
Comley, B. Anthony, S. and Ferguson, B. 2002, The effectiveness of fiscal policy in Australia. Canberra, Australia.
Elmendorf, D. and Mankiw, N.1998, Government Debt, NBER Working Paper Series, working paper 6470, National Bureau of Economic Research, Cambridge, USA.
Mitchell, B. 2010, Twin deficits – another mainstream myth, “Billy Blog”, accessed 19/05/2013. http://bilbo.economicoutlook.net/blog/?p=11527
Mitchell, B. 2010, Budget deficits do not cause higher interest rates, “Billy Blog”, accessed 19/05/2013. http://bilbo.economicoutlook.net/blog/?p=11627
Baldacci, E. and Kumar, M. 2010, Fiscal Deficits, Debt and Interest Rates, IMF Working Paper, International Monetary Fund, Washington, USA.
Ardagna, S. 2009, Financial market behaviour around episodes of large changes in the fiscal stance, European Economic Review, pg37-55.
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