Chinn, Menzie D., and Hiro Ito. The dependent variable is the long-term nominal interest rate. The fiscal policy influences interest rates, tax rates and government spending strategy. “A Simple Panel Unit Root Test in the Presence of Cross-section Dependence.”, Pesaran, M. Hashem, L. Vanessa Smith, and Takashi Yamagata.
The principal components are extracted from the variance covariance matrix of Wr, which contains the observable left-hand side and right-hand side variables of equation (7): where r is the (T×N) matrix of long-term interest rates, stnr the matrix of expected short-term rates, infl is the matrix of expected inflation rates, g that of expected real GDP growth rates and pdef and debt those of expected primary deficits and public debts, respectively. Divergence in long-term interest rates however only started to occur once sovereigns’ fiscal positions deteriorated as a result of the global crisis. In column 1, the dependent variable is the first principal component extracted from Wr while the independent variable is the average expected short term interest rate of the countries in the sample. 8A better measure could be the Net Financial Liabilities of the General Government. Following the rule of thumb proposed by Giannone and Lenza (2008) we decide therefore to include two factors in the estimating equation. Canzoneri, Matthew, Robert Cumby, and Behzad Diba. As mentioned in the text, interest rates “r” are measured after the release of the forecasts in order to avoid reverse causality from interest rates to macroeconomic and fiscal variables. 2010. “Should the European Central Bank and the Federal Reserve be Concerned about Fiscal Policy?”, Jackson Hole, Federal Reserve Bank of Kansas City, Chinn, Menzie D., and Hiro Ito. In the next Section we show that these can be obtained extracting principal components from the set of observable variables of equation (4), {rit, xit}i=1, …, N;t=1, …, T. This estimation technique goes under the name of FAP. In Section 4.2 we discuss the estimation of the unobserved factors and refer the reader to Section 9, Technical Appendix A for more details. 2007. On the other hand, if domestic fiscal policies do not have large impact on interest rates, then borrowing costs might reflect only global factors, with the result that any assessment of the underlying fiscal sustainability should be conditional on whether existing global conditions will prevail in the future. “Panel Unit Root Tests in the Presence of a Multifactor Error Structure.”, Reinhart, Vincent, and Brian Sack. However, there is an ever bigger issue on how to compare these items across countries. “Bootstrapping Factor-augmented Regression Models.”, Gonzalez-Rozada, Martin, and Eduardo Levy Yeyati. Looking at columns 2 and 3 we first notice the importance of accounting for common factors. Section 7 concludes. Spreads are computed with respect to the German long-term interest rate for EMU countries and to the US long-term interest rate for the other countries.
Fiscal policy refers to the government using its revenue and expenditure to influence economic progress in a specific period. “F-test” is the value of the F-statistic for the test of equality of coefficients. The R2 also indicates a good fit. We notice that the results are remarkably stable, with the expected short-term interest rate and the debt to GDP ratio being consistently significant and of similar magnitude.
Expected inflation becomes marginally significant when Finland and Spain are excluded from the sample (Table 10). In this section we check how the importance of the domestic (idiosyncratic) components has been changing over time. The country and time fixed effects are eliminated by means of a standard within transformation applied to the left hand side and observable right hand side variables – See Bai (2009).
Fiscal Policy. This evidence suggests a possible re-pricing of risk in the aftermath of the global financial crisis [see Sgherri and Zoli (2009) for evidence on the EMU]. This paper reconsiders the effects of fiscal policy on long-term interest rates employing a Factor Augmented Panel (FAP) to control for the presence of common unobservable factors. 2012. So for example, for the June and the December issue of each year t, we collect the projections for year t+1. Feldstein, Martin. What Effect Does a Large Federal Deficit Have on Interest Rates?.
They are correlated with measures of initial capital markets integration, current account imbalances and economic and institutional fragility. Countries’ fiscal and macroeconomic policies therefore, affect interest rates not so much directly, but rather indirectly by influencing the magnitude of the spillover effects from global factors. Sgherri, Silvia, and Edda Zoli. Unfortunately they are unavailable for a large sample of countries.
We have found some mild evidence that this might be the case when performing the estimates with rolling windows (see Section 5.2). They find that average debt and average deficit have statistically significant effects on long-term interest rates, with magnitudes between 20 and 60 basis points.
See Dell’Erba and Sola (2013).
Since cross-country aggregates average out idiosyncratic components, for large cross-sectional dimensions they tend to approximate the common factors.
Pesaran, Hashem. 2009. To give quantitative support to our interpretation, we then try to regress our estimated factors on the average short term rate and on the average deficit, respectively. 10Laubach (2009) also includes a measure of real-time output gap to control for cyclical factor. 15The significance of the results is not affected by the bootstrap correction. When looking for the determinants of interest rates the natural starting point is a linear model of the type: where the country intercepts αi capture time invariant heterogeneity across countries. The factor is proxied by the average expected budget deficit of the countries in the sample. Laubach (2009) shows that to correctly capture the effects of fiscal policy on interest rates, it is important to use long-term (5-year head) projections of both fiscal policy and interest rates, which are less likely to be influenced by business cycle considerations. 2011; Eichengreen et al. 2004. 2013.
This third factor tracks very closely the Chicago Board Options Exchange Market Volatility Index (VIX), which is commonly considered an indicator of global risk aversion. 2004. 2009. Faini, Riccardo. 2012). All results are obtained using the FAP.
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