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Budget deficits and interest rates in Germany.

Article Excerpt
Abstract

This study uses the basic toots of cointegration to deter-mine whether there exists a long-term relationship between budget deficits and nominal interest rates in Germany. Maximum eigenvalue, trace, and likelihood ratio tests all affirm that there does apparently exist a long-term relationship between the budget deficit and the nominal interest rate. Accordingly, regression studies and formal causality tests have a reasonable basis for investigating whether budget deficits lead to higher interest rates in Germany. (JEL E43, E6, E62)

Introduction

In order for regression-based studies of the alleged impact of budget deficits on long-term interest rates to have a high degree of credibility, it would be desirable to establish formally that there exists a long-term relationship between those deficits and interest rates. In this vein, the present study applies basic cointegration techniques to investigate these variables for the case of Germany, whose budget deficit effects have been studied a number of times [Evans, 1987; Saltz, 1993], although not so extensively as have those for other nations, such as the U.S. [Barth, Iden, and Russek, 1984; 1985; Cebula, 1988; Hoelscher, 1986; Gissey, 1996; 1999] and the UK [Saltz, 1992; Al-Saji, 1992; 1993]. The framework is an open-economy, loanable funds model.

An Open-Economy Loanable Funds Model

Following earlier studies by Barth, Iden, and Russek [1984; 1985], Cebula [1988], and Hoelscher [1986], the open-economy loanable funds model adopted here is given by:

LR = f(P, er sr, D/Y, K/Y, PCY), (1)

where LR is the nominal long-term interest rate yield; P is the expected inflation rate; er sr is the ex ante real short-term interest rate yield; D/Y is the ratio of the central government budget deficit to the GDP level; K/Y is the ratio of net capital inflows to the GDP level; and PCY is the percent change in real GDP.

Based on the conventional wisdom, the expected signs on the partials in (1) are:

[f.sub.P] > 0, [f.sub.er...

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