The recent resurgence of federal government budget deficits has rekindled debates about the effects of government debt on interest rates. While the effects of government debt on the economy can operate through a number of different channels, many of the recent concerns about federal borrowing have focused on the potential interest rate effect.
Higher interest rates caused by expanding government debt can reduce investment, inhibit interest-sensitive durable consumption expenditures, and decrease the value of assets held by households, thus indirectly dampening consumption expenditures through a wealth effect. The magnitude of these potential adverse consequences depends on the degree to which federal debt actually raises interest rates.
While analysis of the effects of government debt on interest rates has been ongoing for more than two decades, there still is little empirical consensus about the magnitude of the effect, and the difference in views held on this issue can be quite stark. While some economists believe there is a significant, large, positive effect of government debt on interest rates, others interpret the evidence as suggesting that there is no effect on interest rates. Unfortunately, both economic theory and empirical analysis of the relationship between debt and interest rates have proved inconclusive.
We review the state of the debate over the effects of government debt on interest rates and provide some additional perspectives not covered in other reviews. We also present some new empirical evidence on this relationship. The paper is organized as follows. In the second section, we discuss the potential theoretical effects of government debt on interest rates, and provide what we think are some important guidelines for interpreting empirical analysis of this issue.
In the third section, we look at some basic empirical facts about federal government debt and interest rates, review recent econometric analysis of the interaction of federal government debt and interest rates, and introduce some new analysis of this relationship. Finally, in the last section, we summarize our conclusions and briefly discuss the potential effects of government debt on the economy in general.
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