Budget deficits and real interest rates: a regime-switching reflection on Ricardian Equivalence

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 regime-change over a long study period and consider nonlinearities. Using a Markov regime-switching 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 long-term 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 time-varying 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.     

Monetary policy implications of volatility linkages among long-term interest rates

This paper investigates the implications for monetary policy from the increasing integration of capital markets using interest rates. The methodology is a multivariate EGARCH model, which captures the spillover mechanism across markets. The results indicate that since 1990 there have been stronger volatility linkages among markets. Evidence that globalization has influenced the behavior of interest rates is suggested from the way disturbances in a market spill over to other markets, thereby affecting the monetary policy conduct in all markets. As investors now have more information about global bonds, their concerted actions generate more volatility as they continuously rebalance their portfolios.     

The expectations hypothesis and decoupling of short- and long-term US interest rates: A pairwise approach

The link between short-term policy rates and long-term rates elucidate the potential effectiveness of monetary policy. We examine the US term structure of interest rates using a pairwise econometric approach advocated by Pesaran (2007). Our empirical modelling strategy employs a probabilistic test statistic for the expectations hypothesis of the term structure based on the percentage of unit root rejections among all interest rate differentials. We find support for the expectations hypothesis and provide new insights into the nature of interest rate decoupling which are of value to policymakers. The maturity gap associated with interest rate pairs negatively impacts on the probability of stationarity, and also on the speed of adjustment towards long-run equilibrium. We further show that the speed of adjustment has become more sensitive to the maturity gap over time.     

Federal deductibility and local property tax rates

Recent econometric work has suggested that federal deductibility of state and local taxes has raised the proportion of these taxes—especially property taxes—in local budgets. This paper lends additional support to these earlier findings by showing that one channel through which deductibility leads to higher local property tax revenues is by increasing the rate of local property taxation. Specifically, we find that if deductibility were eliminated, the mean property tax rate in our sample would fall by 0.00715 ($7.15 per $1000 of assessed property), or 21.1% of the mean tax rate.     

Federal budget allocation in an emergent democracy: evidence from Argentina

This paper studies the determinants of the distribution of the national budget amongst Argentinean provinces. We evaluate the relevance of the alternative theories of budget allocation using the Arellano–Bond dynamic panel technique. Our results confirm our presumption that Federal funds allocations are dominated by the Executive and the governors while the Congress plays a minor role. Unlike some findings for the US, neither the overrepresentation variables nor the congressional theories find support in our sample. Our paper fills the gap in the literature on Argentina’s fiscal federalism deficient in analysis of the decision making process of the National Budget. This paper is based on a chapter of Osvaldo Meloni’s Ph.D. thesis at the Universidad de San Andrés.     

Stochastic interest rates under rational inattention

This paper introduces state uncertainty due to information-processing constraints into the Vasicek model to examine the impacts of rational inattention. By exploiting the term structure of interest rates, we derive closed-form solutions for the subjective bond price and the corresponding bond yield and find that uncertainty induced by informational frictions plays vital roles in undervaluing the bond price and overestimating the bond yield. Furthermore, we clarify the applications of interest rate dynamics under rational inattention and generate the following results: (i) there is an ambiguous relationship between the investor’s channel capacity and option price; (ii) an increase in state uncertainty via a change in the degree of channel capacity is likely to accelerate investment.     

Forecasting interest rates with shifting endpoints

We consider forecasting the term structure of interest rates with the assumption that factors driving the yield curve are stationary around a slowly time‐varying mean or ‘shifting endpoint’. The shifting endpoints are captured using either (i) time series methods (exponential smoothing) or (ii) long‐range survey forecasts of either interest rates or inflation and output growth, or (iii) exponentially smoothed realizations of these macro variables. Allowing for shifting endpoints in yield curve factors provides substantial and significant gains in out‐of‐sample predictive accuracy, relative to stationary and random walk benchmarks. Forecast improvements are largest for long‐maturity interest rates and for long‐horizon forecasts. Copyright © 2013 John Wiley & Sons, Ltd.     

The relationship between budget deficits and capital inflows: Further econometric evidence

This research note examines the impact of federal deficits on U.S. capital inflows. Expanding on the previous work of Bahmani-Oskooee and Payesteh (1994), we employ the relatively new maximum likelihood procedure developed byJohansen (1988) andjohansen andJuselius (1990) to do cointegration tests. The results find a long run relationship between budget deficits and capital inflows. In addition, findings from error-correlation modeling reveal that short-run disequilibria in financial markets are corrected very rapidly, suggesting that these markets are efficient.     

International linkages between short-term real interest rates

Whereas previous studies have focused on the causal relation between nominal interest rates, this paper examines causal relationships between real rates for the United States and six other countries. Based on evidence from our full sample we find that U.S. and foreign interest rates are not highly informative for one another. This would suggest that even if the United States is regarded as a large player in international financial markets this does not necessarily translate into the transmission of U.S. real interest rates to other countries. However, an examination of various sub-periods of our sample reveals that this conclusion may be sensitive to the U.S. monetary policy regime. We also report results for linkages between European countries which indicate that Germany provides some information on real interest rates in France and the United Kingdom, but not in Italy. An analysis of various sub-periods for the European countries show that the result for France is not robust, with German rates having an impact only in the first period through March 1983. This latter evidence does not provide strong support for the hypothesis that Germany's monetary policy plays a dominant role in the European Monetary System. In general, we would argue that domestic factors play a prominent role in determining real interest rates, quite independently from the influence of interest rates from abroad.     

Optimal dividend policy with random interest rates

Several recent papers have studied the impact of macroeconomic shocks on the financial policies of firms. However, they only consider the case where these macroeconomic shocks affect the profitability of firms but not the financial markets conditions. We study the polar case where the profitability of firms is stationary, but interest rates and issuance costs are governed by an exogenous Markov chain. We characterize the optimal dividend policy and show that these two macroeconomic factors have opposing effects: all things being equal, firms distribute more dividends when interest rates are high and less when issuing costs are high.     

Real and nominal interest rates and the demand for housing

This paper is an empirical study of the relationship between inflation expectations and the demand for housing. The major findings are that housing demand is a function of both expected inflation and the real interest rate but that demand cannot be specified as a function of the nominal rate. It is also shown that expected inflation has a larger impact on those households that are likely to be constrained by capital market imperfections.     

Pricing perpetual options with stochastic discount interest rates

The aim of this study is to investigate the prices and optimal exercise strategies of certain perpetual American options on the asset under stochastic discount interest model. This is different from Gerber and Shiu (N Am Actuar J 2(3):101–112, 1998), in which the interest force was a constant; here we suppose that the accumulated interest function is perturbed by the standard Brownian motion and Poisson process. We obtain an explicit expression of optimal option-exercise boundary in the case of perpetual put option. Moreover, we get a corresponding result when the individual claim is described by an exponential distribution. Finally, we analyze the influence of certain coefficients in stochastic interest model on the optimal option-exercise boundary.     

Higher interest rates should not unduly faze consumers

• ? Though the MPC has signalled a more aggressive pace of interest hikes than previously anticipated, we still expect the impact on the consumer sector in aggregate to be modest. We estimate that household debt servicing costs will rise from the current level of 4.1% of household income to 5.0% by the end of 2019. This would still be only a little over half the pre‐crisis peak.
• ? We expect the MPC to hike interest rates twice in both 2018 and 2019, taking Bank Rate to 1.5% by the end of next year. Higher interest rates will impact on consumer spending by increasing debt servicing costs and reducing the attractiveness of credit (including mortgages), but savers will benefit from higher returns on their deposits.
• ? Mortgages account for 77% of loans to UK households and full pass through of a 100bp rise in Bank Rate to variable rate loans, implying an increase from 2.78% to 3.78%, would add £100 a month to the cost of servicing an average mortgage. But only two‐fifths of borrowers have a variable rate deal, so for many homeowners the adjustment to higher interest rates will not be immediate. And the proportion of houses which are owned via a mortgage has fallen over the past decade, suggesting that the household sector as a whole will be less sensitive to higher mortgage interest rates.
• ? Historically the relationship between Bank Rate and interest rates on unsecured lending has been weak and rates on credit cards and personal loans have not yet risen following November's rate hike. The link to deposit rates has been stronger and higher returns on savings will mitigate some of the damage to household income from higher debt servicing costs, although uneven distribution of debt and savings means that there will be winners and losers at a more disaggregated level.
• ? We have used the Oxford Economics Global Economic Model to run a counterfactual scenario where Bank Rate is kept at 0.5% throughout 2018 and 2019. The results suggest that the pace of rate hikes assumed in our baseline forecast would reduce the level of consumer spending by 0.2 percentage points by the end of 2019.

     

Nonlinear mean reversion in the term structure of interest rates

The expectations hypothesis implies that the yield curve provides information on the future change in the short-term interest rate. However, transaction costs exist in the financial market, which prevent investors from realizing the arbitrage opportunity, when the arbitrage does not fully cover the transaction costs. The purpose of this paper is to assess the effect of transaction costs on the predictability of the term structure by using the threshold vector error correction model, which allows for the nonlinear adjustment to the long-run equilibrium relationship. A significant amount of threshold effect is found, and the adjustment coefficients are regime-dependent. The empirical result supports the nonlinear mean reversion in the term structure of interest rates.     

Long-term interest rates,risk premia and unconventional monetary policy

We study two kinds of unconventional monetary policies: announcements about the future path of the short-term rate and long-term nominal interest rates as operating instruments of monetary policy. We do so in a model where the risk premium on long-term debt is, in part, endogenously determined. We find that both policies are consistent with unique equilibria, that, at the zero lower bound, announcements about the future path of the short-term rate can lower long-term interest rates through their impact both on expectations and on the risk premium and that long-term interest rate rules perform as well as, and at times better than, conventional Taylor rules. With simulations, we show that long-term interest rate rules generate sensible dynamics both when in operation and when expected to be applied.     

Monetary policy regimes and the term structure of interest rates

US monetary policy is investigated using a regime-switching no-arbitrage term structure model that relies on inflation, output, and the short interest rate as factors. The model is complemented with a set of assumptions that allow the dynamics of the private sector to be separated from monetary policy. The monetary policy regimes cannot be estimated if the yield curve is ignored during estimation. Counterfactual analysis evaluates importance of regimes in policy and shocks for the great moderation. The low-volatility regime of exogenous shocks plays an important role. Monetary policy contributes by trading off asymmetric responses of output and inflation under different regimes.     

Housing appreciation, mortgage interest rates, and homeowner mobility

This paper presents a model of the optimal timing of tradeup, which considers consumption and investment motives of homeownership. Households determine the optimal timing of trading up so as to maximize their intertemporal utility of both housing and nonhousing consumption. First we consider current homeowners, who already own a house and expect that they trade up to a more valuable house at some point in the future. Housing appreciation tends to induce an earlier optimal timing of trading up. Moreover, housing appreciation makes current homeowners better off in terms of welfare. However, current homeowners suffer from a rise in mortgage interest rates. Second, we consider first-time home buyers, who have decided to buy a house and expect to trade up to a more valuable house in the future. Their initial housing consumption is determined by an initial downpayment constraint. In this case, the effect of housing appreciation on the optimal timing of trading up is ambiguous and, unlike current homeowners, first-time home buyers suffer from housing appreciation. Moreover, as current homeowners, first-time home buyers suffer from a rise in mortgage interest rates. Most of the theoretical analytic results are ambiguous. Accordingly, we perform numerical simulations based on the theoretical model in order to determine the most likely comparative effects for a stylized set of parameters.As is apparent, the model captures the recent observations on homewner mobility and suggests that macroeconomic variables such as housing appreciation and mortgage interest rates effect the optimal timing of trading up and homeowner's welfare. Nevertheless, the model in this paper has several shortcomings, which should be the subject of future research. First, transaction costs are ignored. If transaction costs are incorporated, the lock-in effect from a rise in mortgage interest rates is well explained. However, the general analysis above is not altered in any essential way. Second, multiple moves are not considered in this model. Therefore, we concentrate on the timing of one tradeup as opposed to the timing and frequency of trading up. In a different vein, it would be interesting to test empirically the importance of the effects of macroeconomic variables on trading up by using microdata.