Saving Constraints, Debt, and the Credit Market Response to Fiscal Stimulus

We document that the interest rate response to fiscal stimulus (IRRF) is lower in countries with high inequality or high household debt. To interpret this evidence we develop a model in which households take on debt to maintain a consumption threshold (saving constraint). Now debt-burdened, these households use additional income to deleverage. In economies with more debt-burdened households, increases in government spending tighten credit conditions less (relax credit conditions more), leading to smaller increases (larger declines) in the interest rate. Our theoretical framework predicts that the negative relationship between the IRRF and debt only holds when credit is not restricted. It also predicts that the consumption response to fiscal stimulus is falling in debt and inequality (only during periods of relaxed credit). We perform a series of empirical tests and find support for these predictions. In doing so, we provide context to recent evidence on the debt-dependent effects of government spending by highlighting that the relationship between debt and fiscal effects varies with credit conditions.