Dynamic Linkages among Budget Deficits, Interest Rates and the Stock Market

Authors


  • Submitted October 2009.

  • The author is grateful to the journal's Editor, Gareth Myles, and an anonymous referee for several constructive comments on the paper. He also wishes to thank Judith Payne for her excellent editorial assistance, which improved the flow of the paper. The usual disclaimer applies.

Abstract

This paper examines the dynamic linkages among the federal budget deficit, interest rates and the stock market for the United States from 1960 to 2006. The empirical strategy includes vector autoregression (VAR) and Granger causality analyses. The results suggest that budget deficits negatively impact upon stock returns, which implies a violation of the Ricardian Equivalence Proposition. Further analysis shows a higher sensitivity of stock returns to corporate taxes than to public spending. Finally, it is shown that although taxes are relevant for corporate profits in the short run, budget deficits are important for the stock market in the long run.

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