Fiscal Policy and Interest Rates: The Role of Sovereign Default Risk

You may be able to download this chapter for free via the Document Object Identifier.

Recent events have highlighted the potential importance of nonlinear effects of fiscal variables (notably debt and deficits) on interest rates: While in times when government solvency is not a concern the standard crowding-out effects are of moderate magnitude, in times when default risk becomes an issue the interest rate effects can become very large. This paper provides new evidence on the magnitude of these effects. For the case in which default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic effects of fiscal policy shocks on interest rates along the entire maturity spectrum. For the case in which default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on European Monetary Union government bond spread regressions on time-varying effects of national fiscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of fiscal policy.