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Is there a correlation between interest rates, inflation and the national debt? 

The possible correlation between the national debt, inflation, and interest rates has been of interest to economists for a long time.  As is typically the case when economists spend time pondering such questions, you get many different answers.  There are many different models of how the economy operates, and many different predictions about how the national debt or national deficits can affect things such as inflation and interest rates.  Ultimately, the empirical evidence is fairly mixed in terms of the actual observable relationship between the national debt, inflation and interest rates.   

To walk through a few of the possibilities, though, we need to define some terms.  We often hear about federal budget deficits and the national debt.  The budget deficit (or surplus) refers to the difference between current government revenues and government expenditures.  Therefore, when U.S. Government spending exceeds tax revenues, we have a budget deficit.  The accumulation of these deficits overtime results in the national debt and budget surpluses overtime allow us to pay off some of the national debt.  How are these deficits financed – or how has the national debt been financed?  The difference between tax revenues and government spending is financed by government bonds of various types and maturities.

Perhaps the clearest predictable link is that between budget deficits and interest rates.  There are several ways to think through this, here’s one shot: When the government issues bonds to finance a budget deficit, there is an increase in the supply of binds in financial markets.  This increase in the supply of bonds should tend to put downward pressure on bond prices.  When bond prices fall, bond yields – interest rates – rise.  Or, given a fixed supply of funds that the public is willing to invest, the availability of more bonds should result in higher interest rates.  If we maintain the assumption of a fixed demand for bonds, these results are fairly straightforward.  However, this is not always the case.  If we have other nations that are willing to purchase U.S. government bonds, then we may not see the impact on interest rates.  Indeed, economic research has produced some substantial variation in terms of trying to uncover the ultimate impact of budget deficits or the national debt on interest rates.  Again, many models predict some upward pressure on interest rates, but the magnitude of the impact remains elusive.  In part, this is because so many other factors work to influence interest rates, including Federal Reserve policies, inflation expectations, and overall economic conditions. 

Finally, economic models may also indicate that budget deficits result in inflation through various channels.  However, the empirical evidence seems to suggest that while this may be the case in developing nations, it is not necessarily the case in the United States or other nations that have a deeper financial system and a central bank that is committed to pursuing low inflation.

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