Budget deficits and real interest rates a regime

Authors: Daniel F S Choi Mark J Holmes

Publish Date: 2011/11/05

Volume: 38, Issue: 1, Pages: 71-83

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Abstract

This paper investigates the relevance of the Ricardian Equivalence theorem for the relationship between the budget deficit and real interest rate In contrast to the existing literature we focus on regimechange over a long study period and consider nonlinearities Using a Markov regimeswitching model applied to two centuries of annual data we find evidence that the US economy switches between a Ricardian Equivalence regime characterized by an insignificant relationship between the adjusted primary budget deficit and real longterm interest rate and a regime characterized by the traditional view of a positive relationship We also find evidence that the transition probabilities between regimes are timevarying insofar as a weaker level of economic activity a lower real interest rate differential between the US and abroad or higher national debts is associated with a weaker relationship between budget deficits and interest rates

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