Term structure of interest rates and fiscal policy

As already mentioned in great detail in Chapter 1, the whole mathematical finance literature dealing with the term structure of interest rates has abstracted from studying the influence of fiscal policy on the term structure. Usually, arbitrary stochastic dynamics for a given set of ‘factors’1 driving the term structure were introduced by postulating specific forms of diffusion processes representing the evolution of these factors. As a consequence of these ad-hoc approaches, the influence of fiscal policy was either completely neglected or introduced in an ad-hoc way, at best 2. One can, of course, argue that the influence of fiscal policy is already integrated in the factor dynamics used, namely in the way the dynamics are parametrized. This implies that these parameters are seemingly policy invariant. When one argues that the influence of fiscal policy is already embedded in such arbitrary parameters with almost no economic meaning, then estimating these models is subject to criticism similar to the well-known ‘Lucas Critique’ 3. As the respective introductory remarks in Chapter 1 should have made clear, we think that fiscal policy does matter for term structure considerations. We will now discuss the term structure of interest rate and the influence of fiscal policy in the macroeconomic setting laid down in the previous chapter.