Budget deficits and interest rates a bounds testing approach evidence from New Zealand

Abstract

This empirical study investigates the impact of budget deficits on long-term interest rates in a New Zealand context. Two measures of inflationary expectations are generated, one using the low frequency component of the CPI, provided by the Hodrick-Prescott filter, and the other using a survey based measure. To overcome unit root pre-testing uncertainty, a 'bounds testing approach' is employed to test for cointegration. A single-equation error correction model is then used to test the relationship. Evidence is found in favour of a positive long run relationship between budget deficits and long-term interest rates, suggesting a 'crowding out' effect.