Fiscal Policy and the Term Structure: Evidence from the Case of Italy in the EMS and the EMU Periods

We study the relationship between the term structure of interest rates and
fiscal policy by considering the Italian case. Empirical analysis has been so
far rather inconclusive on this important topic. We abscribe such evidence
to three problems: identification, regime-switching and maturity effects. All
these aspects are particularly relevant to the Italian case.
We propose a parsimonious model with three factors to
represent the whole yield curve, and we consider yield
differentials between Italian and German Government bonds.
To take into account the possibility of regime-switching, we explicitly include
a hidden two-state Markov chain that represents market expectations. The
model is estimated using Bayesian econometric techniques. We find that government
debt and its evolution significantly influence the yield of government
bonds, that such effects are maturity dependent and regime-dependent. Hence
when investigating the effect of fiscal policy on the term-structure it is of crucial
importance to allow for multiple regimes in the estimation.

Kewords: Fiscal Policy, Term Structure, regime switching, Bayesian estimation