Review of Quantitative Finance and Accounting, 14 (2000): 5±15
# 2000 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
The Relationship between Federal De®cits and Real
Department of Finance and Business Law California State University, 5245 N. Backer Avenue, Fresno,
Abstract. Real interest rates ¯uctuated a great deal since the 1970s. In the 1980s federal de®cits accelerated and
their impact on both nominal and real interest rates gained lots of attention. Based on monthly and quarterly data
from January 1971 to December 1997 it is found that federal de®cits had signi®cant positive effect on the real
interest rates: Personal income or consumption are found to have signi®cant positive impact on the real interest
rates, whereas expected in¯ation and money supply are found to have negative impact on the real interest rates.
These ®ndings are consistent with the conventional economic theory.
Key words: real interest rate, federal de®cit, IS-LM curve, nominal interest rate, autoregressive model
JEL Classi®cation: E4
Abnormally high real interest rates coupled with the rising federal de®cits in the 1980s
have motivated many researchers in recent years to search for reasons to explain the
aberrations. Recently, the Federal Reserve policy makers have paid some attention toward
monitoring the behavior of nominal and real interest rates after realizing that the velocities
of both M1 and M2 have become more volatile or unstable. Although the Fed is still
watching closely the growth of the monetary aggregates and other variables, the real
interest rates have become one of its important monetary policy targets.
There are four basic views regarding the high real interest rates experienced in the
1980s. One of the most widely held views is based on the traditional macroeconomics by
applying the IS-LM curve model to study the effect of increasing federal budget de®cits in
the 1980s. Studies by Darrat (1989, 1990), Dewald (1983), Evans (1985, 1987), Makin
(1983), and Motley (1983) found no relationship between federal budget de®cits and the
real interest rates. On the other hand, Cebula (1990), Hoelscher (1986), Tanzi (1985), and
Zahid (1988) found a signi®cant positive relationship between the federal de®cits and the
real interest rates. In addition, based on an international study for seven major
industrialized countries (Canada, France, Germany, Italy, Japan, U.K. and U.S.)
Hutchinson and Pyle (1984) found a signi®cant positive relation between the real interest
rates and the federal de®cits. Barth, et al. (1991) provided the most extensive survey of
recent studies and found inconclusive evidence on that relationship. More recently, in a
U.K. study Al-Saji (1993) again found a signi®cant positive relation between the federal
de®cits and the real interest rates.