Do Budget Deficits Affect Real Interest Rates? A Test of Ricardian Equivalence Theorem

This study re-examines the Ricardian Equivalence theorem (RET) by using advanced time series econometric models to investigate updated data of the U.S. budget deficits and real interest rates. We employ a multi-model approach to thoroughly investigate the properties of two time series, namely the U.S. federal budget deficits (BDEF) and real interest rates (INTRATE) for the study period from 1798 to 2009. It is found that BDEF and INTRATE are I(0) processes. The AR (2) is the most appropriate model for the BDEF series, while the ARMA (3,2) is the proper model for the INTRATE series. The estimated VAR (2) model, comprising the two stationary series BDEF and INTRATE, implies that the BDEF series has no effect on the INTRATE series. The Granger-causality test also shows that there is no direction of causality from the BDEF series to the INTRATE series. Our findings are consistent with what the Ricardian Equivalence theorem predicts and, therefore, support the proposition that the budget deficits are neutral. This study significantly contributes to the extant literature of the relationship between the budget deficits and the real interest rates by applying the multi-model approach. Furthermore, our long time series dataset enables us to make reliable inferences.