The behaviour of long-term interest rates plays an important part in our account of how fiscal consolidation policies may work, and this chapter is devoted to discussing this topic. We would like to know how long-term interest rates are determined and how fiscal consolidation policies (and other policies) may change them.

Many macroeconomic models assume there is just one interest rate, so the distinction between short-term and long-term interest rates does not arise. Such an assumption may be appropriate for some purposes, but not for the topic under consideration, as the behaviour of long-term interest rates when short-term interest rates are at their lower bound is a crucial part of our explanation. Long-term rates may move when short-term rates do not, so it is impossible to think in terms of just one interest rate.

The question of how short-term interest rates are related to long-term interest rates or, more broadly, how the term structure of interest rates is determined, has of course been much studied by economists, and several hypotheses have been developed. Understanding the relationship between short-term rates and long-term rates is important in many areas of macroeconomics, especially monetary policy. Monetary policy makers, who control short-term interest rates, will certainly want to know the effects of their actions on longer-term interest rates. This is what theories of the term structure of interest rates seek to explain. The “term structure” is a statement of the rates of return on bonds of different maturities. There are a number of theories, such as the expectations hypothesis, the preferred habitat hypothesis, the segmented markets hypothesis and so forth (see Malkiel 2008 for a review of theories of the term structure). We will start our discussion by considering the expectations hypothesis, which holds when investors are risk neutral; other hypotheses, which relax this assumption, can then be related to this.

If investors are risk neutral, they will choose to hold a portfolio of assets which maximizes their expected return over the period in question. If an investor can obtain 2 per cent on a one-year bond and expects to obtain 4 per cent on a one-year bond in a year's time, he will expect a return of about 3 per cent (annualized) over the next two years from a strategy of buying the one-year bond now and re-investing the proceeds in another one-year bond in a year's time.