THE TEMPORAL CAUSALITY BETWEEN FISCAL DEFICITS AND INTEREST RATES

Conventional wisdom suggests that higher government fiscal deficits cause higher (long-term) interest rates. Much empirical work-generally standard ordinary least squares (OLS) regression analysis-has examined this issue and has produced mixed findings. Even if these standard OLS studies conclude that deficits and interest rates are related, they do not answer the question of which came first-the higher deficit or the higher interest rate? A few studies have used Granger causality to consider the question of temporal causality, generally with short-term interest rates. Tliis paper employs the relatively new cointegration and error-correction methodology to reexamine the temporal causality between fiscal deficits and interest rates-both long term and short term. This study finds evidence that federal deficits cause the long-term interest rate. Copyright 1991 Western Economic Association International.