17The country and time fixed effects are eliminated by means of a standard within transformation applied to the left hand side and observable right hand side variables – See Bai (2009). 2013. Suggested Citation, Avenue de la paix 11AGeneva, CH-1202Switzerland, 700 19th Street, N.W.Washington, DC 20431United States, International Monetary Fund (IMF) Research Paper Series, Subscribe to this free journal for more curated articles on this topic, Macroeconomics: Monetary & Fiscal Policies eJournal, Subscribe to this fee journal for more curated articles on this topic, Public Economics: Fiscal Policies & Behavior of Economic Agents eJournal, Econometric Modeling: Capital Markets - Risk eJournal, Comparative Political Economy: Fiscal Policy eJournal, Political Economy - Development: Fiscal & Monetary Policy eJournal, We use cookies to help provide and enhance our service and tailor content.By continuing, you agree to the use of cookies. These shocks have triggered a heterogeneous increase in borrowing costs with larger effects for those countries which, while benefiting from the capital markets integration, had also accumulated larger imbalances. As a second exercise, we measure the impact of fiscal policy on the yield spreads measured as the difference between the ten years yield and the yield on a risk-free asset of the same maturity (r–rB). The deficit gap is the product between the debt to GDP ratio and the difference between expected deficit and the deficit which would stabilize the debt to GDP ratio (see Appendix B). Under the assumption that financial markets are forward looking and are able to incorporate rapidly all the available information, sampling interest rates after the release of the forecasts reduces the issue of reverse causality. Giannone, Domenico, Michele Lenza, and Lucrezia Reichlin. The top panel shows the first factor plotted against the average expected short-term interest rate of the countries in the sample. Following Giannone and Lenza (2008) we therefore assume a factor structure of the type: in which observable quantities {rit, xit} are a function of a set of q unobservable global factors {ftk}k=1q with heterogeneous impact in each country {λkir, λkiX}k=1q, ∀i: 1, …, N. Given this data generating process, an accurate estimate of the effect of macroeconomic and fiscal policy variables on interest rates should be based on the idiosyncratic components only: Equation (3) cannot be estimated because the idiosyncratic components {ritID, xitID} are unobservable, but we can use (2) to substitute the idiosyncratic component in (3) and rewrite the equation in terms of observable quantities and global factors: By taking explicitly into account the global factors {ftk}k=1q, (4) allows us to estimate the relationship between the idiosyncratic components of the variables of interest. While we cannot directly compare our estimates to Laubach’s (2009) due to differences in the underlying datasets and specifications used in the estimation, we can refer to Laubach’s analysis (2009) to reconcile our results with economic theory. The dependent variable is the long-term interest rate. Posted: 31 Jul 2013, University of Geneva - Graduate Institute of International Studies (HEI). “How the Subprime Crisis Went Global: Evidence from Bank Credit Default Swap Spreads.” Journal of International Money and Finance 31 (5): 1299–1318. The factor is proxied by the average expected budget deficit of the countries in the sample. This third factor tracks very closely the Chicago Board Options Exchange Market Volatility Index (VIX), which is commonly considered an indicator of global risk aversion. Global factors and their macroeconomic interpretation. “Inflation and Real Interest.”, Pesaran, Hashem. We also used current period GDP and trend GDP measured with a Hodrick-Prescott filter as a scaling variable obtaining similar results. When the data generating process is represented by the system in (2), we can obtain unbiased estimates of the coefficients β only if we allow the factors to have heterogeneous impact across countries (δki≠δkj). The last column of Table 11 includes a new variable, the deficit gap which is computed as in Faini (2006). In particular, we show that the effects of fiscal policy are significant, but quantitatively small: a 1 percent increase in fiscal deficit leads to an increase in long-term interest rate by 8–11 basis points; a 1 percent increase in public debt to GDP ratio leads to an increase in long-term interest rate of 1.2–2 basis points. Baseline estimation – long-term interest rates. The figure shows that the share of variance explained by the first three global factors tends to be relatively stable over the sample period, with three principal components explaining between 70 and 80 percent of the variance in the data. 37Non-linear effects of crisis periods are stronger when looking at sovereign spreads rather than long-term interest rates. The compression of long-term interest rates which occurred in OECD countries prior to the crisis could be explained by the fiscal retrenchment which took place among industrialized countries at the beginning of the nineties and the lowering of inflation premia due to a shift to credible inflation targets. However we also show that long-term interest rates are affected heterogeneously by these common factors, which have larger impact on countries with macroeconomic vulnerabilities. In open economies, in fact, nominal rates will rise less than one-for-one with inflation because of a substitution from money to bonds, thus higher expected inflation reduces ex-ante real interest rates [the “Mundell-effect,” Mundell (1963)] (Table 8 column 1). “New Evidence on the Interest Rate Effects of Budget Deficits and Debt.” Journal of the European Economic Association 7 (4): 858–885. Column 3 performs the estimator of Greenaway-McGrevy, Han, and Sul (2012) as discussed in Gaibulloev, Sandler, and Sul (2014). 9We also tried using the actual 3 months interest rate from Datastream obtaining very similar results. Interest rates remain low throughout the 2000 particularly so in Japan, and they begin to diverge only during the crisis. All other trademarks and copyrights are the property of their respective owners.