Discrete Affine Term Structure Models Applied To The Government Debt And Fiscal Imbalances

This paper discusses the relationship between government deficits and changes in total debt outstanding as well as the relationship between yields and real interest rates, inflation expectations and credit spreads using inflation linked swap data. This study also shows how affine term structure models (ATSMs) can be used to link the theory of the price level to term structure dynamics. When central banks are independent, increases in government deficits result in increases in the credit spreads and not necessarily in increases in the price level. Empirical results show that when modelling Spanish and Greek government yields fitted values improve significantly when credit spreads are included in the state vector. Most importantly, this study shows how affine term structure models can be used for the analysis of the time path of changes in government debt, government primary surplus and credit spreads. Finally, another novelty of this work is to apply the ATSM methodology to describe, for instance, how EU-governments' deficits deteriorate as a consequence of the time path of shocks in macroeconomic variables such as unemployment, as unemployment shocks can have widening effects on governments' fiscal imbalances and this will vary depending on the governments' risk profile.