How do governments respond to interest rates?

We explore the optimal and actual responses of fiscal policy to changes in the interest rate on newly-issued public debt (the “marginal interest rate”). We set up a simple theoretical framework with a government aiming to smooth public consumption over time. The distinctive feature is that the government issues debt of different maturities. This introduces a “valuation effect” that has received little attention so far: a rise in the marginal interest rate increases the rate of discounting and, thus, lowers the value of non-maturing debt, which relaxes the budget constraint, thereby inducing a fall in the primary balance. Still, the framework predicts that the total effect of a rise in the marginal interest rate is an increase in the primary balance. Estimates for developed countries suggest that a 1 percentage-point higher marginal interest rate leads, on average, to roughly a 1 percentage-point higher primary balance. These findings are consistent with governments smoothing the impact of changes in the marginal interest rate and exploiting the valuation effect. Finally, estimates suggest a role for the average (or “effective”) interest rate on outstanding debt.