DP79 | Interest Rates and Bond-Financed Deficits in a Ricardian Two-Party Democracy


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The thesis of this paper is that political differences between parties are a major explanation of inflation and variations in it, and therefore introduce into real interest rates a risk premium which will vary with creditors' exposure to 'inflationary default', i.e., with the level of public debt. The paper tests a number of predictions of this theory. First, that political parties do differ in their policy behaviour (contrary to the median voter theorem); this is clearly supported by postwar evidence for the United Kingdom, West Germany and Sweden. Second, expected real interest rates on bonds are related to budget deficits and/or public debt, according to evidence for the United States and United Kingdom from 1920 to 1982. Third, we find some modest but (as we expected from the indirectness of the relationship) rather weak evidence of a connection between which party was in power and the level and variability of inflation in the same period for these two countries. Fourth, the theory provides a rationale for the commonly observed relationship between inflation and its variability.