Fiscal policies are economic tools utilized by government to manipulate the level of total demand for final goods and services in an economy. Interest rates are one of the economic factors used to influence the rate of consumption by consumers. Fiscal policies relating to interest rates may either be expansionary or aimed toward the contraction of demand for goods and services.
In most basic terms, fiscal policy is government spending and taxation. How much the government decides to spend and tax rates, make up the government's fiscal policy. When government spending is less than government revenue, it is said that a contractionary fiscal policy is in place. If the government is spending more than the revenue, it is said to be engaging in expansionary fiscal policy.
There is general consensus among economists that fiscal policies may and often do have an effect on interest rates. However, there are differing opinions on what this effect is, the significance of the effect and how different factors impact the relationship. One of the most prevalent ideas about the relationship between fiscal policies and interest rates is that fiscal expansion raises interest rates. So when the government is spending more than its revenue, interest rates will go up.
A 2013 IMF working paper found that fiscal policy, together with global monetary policy, account for more than 60% of variances in long-term interest rates. Those who carried out this study argue that the relationship between national fiscal policy and interest rates is weaker if one does not count for global fiscal factors. Another paper, written by the Research Institute of Applied Economics in 2008, argues that large deficits have significant effects on interest rates but some factors like spillover reduces these effects.
Economists continue to study the relationship between fiscal policy and interest rates. It is important to better understand this relationship because it can assist economists and policy makers to develop better fiscal policies, as well as estimate more accurately the consequences of current policies.