Macroeconomics II
Universidad de Valencia

“Financial Markets, Expectations and Monetary Policy in 2009“

Report

Issued by

30.04.2010
Table of contents
Table of contents II
Figures III
1 The Fisher effect 1
1.1 Three year bond interest rates and annual (CPI) inflation rate 1
1.2 Public deficit and interest rates 4
2 Financial markets and interest rate expectations 8
3 ECB policy and market expectations 11
4 Interest rates and exchange rates 17
5 The current recession 20
5.1 Main views 20
5.2 Impact 20
5.3 Causes 21
5.4 Impacts 22
Sources 24

Figures Figure 1: Great Britain 2 Figure 2: Japan 2 Figure 3: USA 2 Figure 4: Spain 3 Figure 5: Spain public deficit / GDP (%) 5 Figure 6: Daily interest rates …ver más…

Public deficit and interest rates
The relation between the public deficit and interest rates is a controversial question subject to various theoretical approaches, many empirical studies and frequent political disputes. The overall balance of the debate seems to suggest that the impact of the public deficit on interest rates is modest when it is moderate and seen as controllable. Nevertheless, it can cause chaos in capital markets if the sustainability of the public finances is put in question.
There are two basic channels through which public deficits can affect interest rates. First, a high public deficit may change the balance between aggregate savings and investment, pushing up the real interest rate of the economy (and therefore of financial instruments as a whole). Second, deficits increase the stock of government bonds in absolute terms and in terms relative to other financial assets. The worsening (present and expected) of the financial position of the public sector may raise the risk premium for default incorporated in the interest rate on government bonds. The conventional theoretical focus, inspired by Keynesian thinking, postulates that deficits provoke an increase in interest rates. This analysis sets out from the accounting position under