Response of the Long-term Interest Rate to the Government Deficit in Italy: Application of an Extended Loanable Funds Model

Extending the open-economy loanable funds model, this paper finds that more government deficit or debt as a percent of GDP does not result in a higher long-term interest rate, that a higher real treasury bill rate, a smaller percent change in real GDP, a higher expected inflation rate, a higher world interest rate, or expected depreciation of the euro would increase Italy’s long-term interest rate. When the standard closed-economy or openeconomy loanable funds model is considered, the same conclusion that more government deficit does not lead to a higher long-term interest rate is reached. The insignificance of the coefficient of the percent change in real GDP and the marginal significance of the ratio of the net capital inflow to GDP in the standard open-economy loanable funds model suggest that the extended open-economy loanable funds model presented in this paper improves the specification of the model and empirical outcomes.