Communications in Mathematical Finance

A Model of the Term Structure of Interest Rates with Fiscal-Monetary Policy Interactions

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  • Abstract

    We study the implications of fiscal factors for the term structure of interest rates. We embed the flow budget constraint of the government into a general-equilibrium model of the bond yields. In our framework, the interaction between monetary and fiscal policy affects the ability of the government to meet the the solvency requirement. We assume that the tax rate is set according to a simple rule whereby taxes react proportionally to the outstanding liabilities of the government. A weak response of the fiscal authority to changes in public debt contributes to determine the inflation rate, thus acting as a driver of the term structure of interest rates. We depart from a discrete-time model that allows a clear-cut intuition, and price the term structure through the continuous time limit. Since the model does not allow a closed-form solution, we use numerical methods to compute the prices of real and nominal zero-coupon bonds.