Deficits urul interest rutes
The dramatic change in the US budget position after 2000 (from a surplus to a large and continuing deficit) reinvigorated the debate about the effect of fiscal policy on interest rates. This problem asks you to review theory and evidence on this topic.
a. Review what theory predicts about fiscal policy and interest rates. Suppose there is an increase in government spending and a decrease in taxes. Use an IS-LM diagram to show what will happen to the nominal interest rate in the short run and in the medium run (assuming the Fed is following an interest rate rule and has an implicit inflation target). Assuming that there is no change in monetary policy, what does the IS-LM model predict will happen to the yield curve immediately after an increase in government spending and a decrease in taxes?During the first term of the G. W. Bush administration, the actual and projected federal budget deficits increased dramatically. Part of the increase in the deficit can be attributed to the recession of 2001. However, deficits and projected deficits contimued to increase even after the recession had ended. The following table provides budget projections produced by the Congressional Budget Office (CBO) over the period August 2002 to January 2004. These projections are for the total federal budget deficit, so they include Social Security, which was running a surplus over the period. In addition, each projection assumes that current policy (as of the date of the forecast) continues into the future.$$
\begin{array}{|lc|}
\hline \text { Date of forecast } & \text { Projected five-year deficit as per cent of five-year GDP } \\
\hline \text { August } 2002 & -0.4 \\
\hline \text { January } 2003 & -0.2 \\
\hline \text { August } 2003 & -2.3 \\
\hline \text { January } 2004 & -2.3 \\
\hline
\end{array}
$$
b. Go to the website of the Federal Reserve Bank of St Louis, (http://research.stlouisfed.org/fred2), and follow the links to 'FRED Economic Data, then 'Categories', under Interest Rates' and then Treasury Constant Maturity', obtain the data for '3-Month Constant Maturity Treasury Rate' and '5-Year Constant Maturity Treasury Rate' for each of the months in the table shown here. For each month, subtract the three-month yield from the five-year yield to obtain the interest rate spread. What happened to the interest rate spread as the budget picture worsened over the sample period? Is this result consistent with your answer to part (a)?
The analysis you carried out in this problem is an extension of work by William C. Gale and Peter R. Orszag. See 'The economic effects of long-term fiscal discipline', Brookings Institution, 17 December 2002. Figure 5 in this paper relates interest rate spreads to CBO five-year projected budget deficits from 1982 to 2002.