Question

The common theory about the spreads in the government bond interest rates in a monetary union is that these spreads reflect default risks. The default risk in turn is determined by a number of fundamental variables. The most important of these variables is the government debt-to-GDP ratio which is a measure of the potential of a government to service its debt. When the government debt-to-GDP ratio increases, the burden of the debt service increases leading to an increasing probability of default. The current account has a similar effect on the spreads: current account deficits should be interpreted as increases in the net foreign debt of the country as a whole.

The table below is from the study of de Grauwe and Ji (2012) for the Eurozone economies reporting the determinants of the long-term government bond rate spread of each Eurozone country against Germany (%) using panel data.

Table 2. Long-term government bond rate spread against Germany (%)
	1	2	3	4
	Pre-crisis	Post-crisis	Pre-crisis	Post-crisis
Current account GDP ratio	0.0011	-0.0033	0.0032	0.021
	[0.0051]	[0.0457]	[0.0064]	[0.0384]
Debt to GDP ratio	0.0077	0.1029	-0.0031	-0.0865
	[0.0037]	[0.0280]	[0.0107]	[0.0216]
Debt to GDP ratio squared			0.0001	0.0012
			[0.0001]	[0.0001]
Country fixed effect	Controlled	Controlled	Controlled	Controlled

Notes: Standard errors are shown in brackets.

Assuming the calculations of the authors are correct, answer the following questions (use the |t|>2 rule of thumb in your answers to indicate significance at the 95% level):

a) What is the regression equation in specification (4)?

b) Interpret the results of specification (3).

c) Compare the results of specification (3) with those of specification (4).

d) Given that the interest rate spread reported in the table above is meant to capture default risk, what do the findings of the above table indicate to the policy makers? Explain your point.

Answer 1

Answer

a.

The regression equation which is used in such a specification is depicted below:

Σν)Σx)- (Σκ) Σxy) n(Σx2) - (Σκ)2 n (Σαν)- (Σx)Σ) n (Σx?)- (Σκ)?

The equation of a is shown on the X-axis whereas on the other hand the equation of b is shown in the Y-axis respectively.

b.

It can be interpreted at both the time of the pre and post-crisis where the pre-crisis must be depicted in the X-axis whereas on the other hand the post-crisis is depicted in the Y-axis respectively. The two parameters of consideration are the current account GDP ratio and Debt to GDP ratio. It is quite significant for Germany to leverage the debts in comparison to that of the GDP of the country. The Pre-Crisis debts of the country have a higher percentage incomparable to that of the Post Crisis. It is important to have stringent control over those debts which are associated along with that effective utilization of the debt in the projects will help to bolster the GDP of the country. On the other hand, the current account GDP investments of the country are less in comparison to the debts incurred by the country which is quite an aggressive strategy adopted by Germany.

c.

The results can be interpreted from the given table where it can be said that the post-crisis figure is negative because debt is higher by a greater margin which is 0.1029. The third option in the table reflects that due to higher current account GDP ratio maintenance, the debt to GDP ratio went down to -0.031. This is a negative outcome under the hood of the pre-crisis.

d.

The policymakers understand the implication of the risk which is associated with the country along with that the effective control of the government is taking into consideration at the same time. The policymakers must upgrade the terms and conditions associated in this case along with that it is needed to forecast the post-crisis impact on the GDP of Germany. This is some of the key findings and situation which must be considered by the policymakers at the time of decision making.