How to stimulate the Danish economy after the COVID-19 lockdown
Recent research from CEBI provides key estimate for the current discussions about the right fiscal stimulus policies to curb the financial downturn after the COVID-19 lockdown.
Claus Thustrup Kreiner, Søren Leth-Petersen, and David Dreyer Lassen published the paper “Liquidity Constraint Tightness and Consumer Responses to Fiscal Stimulus Policy” in American Economic Journal last year. They explain the study:
“In the aftermath of the financial crisis in 2008 governments across the world adopted unprecedented fiscal stimulus policies with the aim of increasing household consumption to boost aggregate spending. Many empirical studies have documented that consumers do raise spending in response to stimulus policy. But the results are in contrast to the prediction of the Permanent Income Hypothesis/ canonical life-cycle model with perfect capital markets where tax rebates just raise household savings, without having any stimulus effect on the economy.
A standard explanation for this prediction failure is the prevalence of liquidity constraints. If some households are constrained by lack of access to liquidity, then a stimulus payment reduces the tightness of the constraints and boosts the spending of these households.
We employ a unique dataset with information about all household borrowing and saving at the account level to provide a direct test of the importance of liquidity constraint tightness.
A challenge is that the difference in access to liquidity is one of degree and not of kind in that the tightness of liquidity constraints is a continuous variable reflecting how costly additional liquidity is to the consumer, and it is this shadow value of liquidity that theoretically determines the propensity to consume.
For example, one consumer may have collateral and borrow at a low interest rate, while another may have used up his collateral-backed line of credit and therefore pays a higher interest on the last dollar borrowed. The marginal interest rate is the rate of interest at which a household can access additional liquidity.
We demonstrate in a basic consumption model how variation across consumers in the marginal interest rate observed prior to the stimulus policy—measuring liquidity constraint tightness—predicts variation in spending responses to stimulus policy.”