Federal Borrowing and Short Term Interest Rates

This paper is an empirical study of the effects of Federal government borrowing on short term interest rates. It is often taken for granted that increases in Federal borrowing cause higher short term rates, but little empirical support exists for this assumption. In fact, this paper demonstrates that Federal borrowing is a relatively unimportant (and insignificant) determinant of short term rates. An implication of this result is that financial crowding-out effects of government deficit spending may not be overly large. Postulates about interest rate behavior are the driving force behind many hypotheses of the crowding-out literature. However, these interest rate effects have received relatively little direct attention in this literature. This is surprising since, as a general rule, the stronger the interest rate effect is, the stronger the crowding-out effect will be. An empirical determination of the size of the deficit spending interest rate effect gives some empirical content to the crowding-out controversy. In Section II of this paper, the relationship between Federal borrowing, interest rates, and crowding-out is discussed and a loanable funds model of short term interest rates is developed. In Section III, the regression model is generated and tested. The essential result is that variation in three month Treasury Bill rates is caused by expected inflation, changes in the monetary base, and by changes in the level of economic activity. There is no statistically significant relation between short term interest rates and Federal borrowing. In Section IV, additional regression tests are performed which confirm the results in Section III, and the problem of simultaneous equation bias is discussed. The final part of the paper is a discussion of some implications of the results reported in Sections III and IV.