An Empirical Analysis of the Relationship Between Government Debt and Interest Rate Fluctuations in Developed Economies

Posted: Feb 10, 2021

• Daniel Rivera
• Daniel Young
• David Nelson

Abstract

This paper presents a novel empirical investigation into the complex relationship between government debt levels and interest rate fluctuations in developed economies, employing an innovative methodological framework that combines traditional econometric approaches with machine learning techniques. Unlike previous studies that primarily focus on linear relationships and conventional macroeconomic variables, our research introduces a multi-dimensional analytical approach that incorporates behavioral economics, market sentiment analysis, and network effects between sovereign debt markets. We develop a unique dataset spanning 25 developed economies over a 30-year period, enriched with unconventional indicators including political stability metrics, institutional quality indices, and real-time market sentiment data derived from natural language processing of financial news. Our methodology employs a hybrid approach combining vector autoregression models with random forest algorithms to capture both linear dependencies and complex non-linear interactions. The findings reveal several counterintuitive relationships, including threshold effects in debt-interest rate dynamics and significant variations across different monetary policy regimes. Particularly noteworthy is our discovery of asymmetric responses in interest rates to debt accumulation during periods of economic expansion versus contraction, challenging conventional wisdom about fiscal-monetary policy interactions. The research contributes to both theoretical understanding and practical policy formulation by providing a more nuanced framework for analyzing sovereign debt sustainability and its implications for monetary policy effectiveness in advanced economies.