Page 65 - ES 2020-21_Volume-1-2 [28-01-21]

48 Economic Survey 2020-21 Volume 1

1. Easing financial constraints:

• Tagkalakis (2008) shows that the fiscal policy is more effective in boosting private
consumption during recessions (for OECD countries from 1970-2002) due to the
presence of binding liquidity constraints on households. Since during recessions liquidity
constraints might bind across a wider range of households and firms, thus a larger
fraction of households and firms will consume the extra income generated following
an unanticipated tax cut or government spending increase, leading to greater impact on
consumption (wealth effect) and hence output.
• On similar lines, Canzoneri et al (2012) argue that fiscal stimulus decreases the spread
(between the bank deposit rate and the bank loan rate), which fluctuates counter cyclically
due to the cyclical variation in bank intermediation costs. This in turn encourages more
borrowing and spending, which further expands the economy and decreases the spread
again, encouraging more borrowing; and the process repeats itself. Since this financial
friction (spread) increases during recession, therefore the chain effect of fiscal stimulus
in boosting borrowings and output is greater during recession compared to expansionary
periods.

• Fiscal multipliers are likely to be higher in recessionary periods because private savings
increase through the precautionary motive to save. Therefore, any potential crowding
out of private investment - even if at all it manifests during expansionary periods - is
unlikely to manifest because of the increased pool of loanable funds.

• Michaillat (2014) documents another channel through the labour market that enhances
the fiscal multipliers in a recession. Increasing public employment stimulates labour
demand, which increases tightness and therefore crowds out private employment.
Critically, the quasi-labour supply is convex. Hence, when labor demand is depressed
and unemployment is high, the increase in tightness and resulting crowding-out are
small.
2. Enhanced consumer sentiment for future productivity increases:

• Bachmann and Sims (2011) argue and present evidence that a spending shock during
periods of economic slack leads to a persistent increase in the amount of government
investment relative to government consumption during a downturn(which is not the case
in normal times). This relative increase in government investment spending provides
signals about future increases in output and productivity, and hence are reflected in
higher measured confidence. This results in higher impact on consumption and output.

THE (r-g) DiFFERENTiAL AND DEBT SuSTAiNABiLiTY iN iNDiA

2.4 As fiscal policy relates very closely with the debate on public debt, we start by understanding
the conceptual underpinnings of the relationship between public debt and growth, as seen in the
simple equation for debt dynamics discussed in Box 3. From the equation, it can be seen that
the debt-to-GDP ratio remains stable over time (i.e. d = d ) if the primary deficit is equal to
t–1
t