Effects of government debt on interest rates: evidence from causality tests in johansen-type models

This paper examines the impact of government debt on interest rates in the United States, Germany, the United Kingdom and Canada, using the sequential causality test procedures suggested by Toda and Phillips (1994) in the Johansen error-correction model (ECM). The general portfolio balance model, which allows for both direct and indirect tests of the link between public debt and interest rates, is used as the economic framework. Indirect tests in this model consist of investigating the debt impact on interest rates through the effects of debt on the exchange rate and money demand. The evidence generally indicates the absence of causality in the long-run, between government debt and interest-rate related variables for all four countries under study. This suggests the neutrality of public debt on interest rates and is consistent with the Ricardian equivalence hypothesis.