Government Debt and Household Consumption: The Influence of the Wealth Channel

This chapter explored whether the increase in the government debt levels has an impact on credit conditions, business and consumer confidence, and the components of GDP. Evidence reveals that a positive standard deviation in government gross loan debt toGDP rationleads to a significant tightening in credit conditions. In turn, the unexpected tightening in credit conditions index leads to a significant contraction in output, household consumption, investment, business, and consumer confidence. The counterfactual analysis shows that the credit conditions channel transmits positive government debt shocks to output, investment, and household consumption as they decline more when the credit conditions channel is operational in the model than when it is shut off. This suggests that tightening in credit conditions index due to an unexpected increase in government debt worsens the delay in the recovery of economic growth. In addition, the lack of a clear fiscal consolidation plan is viewed as less credible and could be weakening capital formation and consumption via the increased risk premium which does not restore optimism about expected wealth. These results imply the need for close coordination between fiscal and monetary policy, a clear and credible fiscal consolidation path that should loosen the credit conditions index following an unexpected increase in government gross loan debt.