A Dependent Economy Model of Employment, Real Exchange Rate and Debt Dynamics: Towards an Understanding of Pandemic Crisis

Published date01 February 2022
Date01 February 2022
Subject MatterOriginal Articles
A Dependent Economy
Model of Employment,
Real Exchange Rate
and Debt Dynamics:
Towards an Understanding
of Pandemic Crisis
Moumita Basu1 , Rilina Basu2 and
Ranjanendra Narayan Nag3
Given the unforeseen and uncertain circumstances during the pandemic, the role
of government expenditure becomes extremely relevant in sustaining lives and
livelihoods of the masses. This brings forth public sector deficit as a key issue of
macroeconomic policy debate. This article aims at investigating the effects of an
unanticipated adverse shock like COVID-19, on the real value of public debt, in
a small open economy, consisting of traded and non-traded sectors, along with
proposed management of such crisis with fiscal and monetary expansion. The
results of policy-induced and exogenous shocks depend on the difference in the
speeds of adjustments in real exchange rate, interest rate and real value of debt,
and the associated multitudes of cross effects. While an unanticipated adverse
shock like COVID-19 causes contraction of both traded and non-traded sec-
tors and reduces consumption expenditure, investment expenditure and level of
employment and real value of aggregate income in the short run, fiscal expansion
causes higher real value of debt and lower real exchange rate.
JEL Codes: E12, E62, H63
Debt dynamics, real exchange rate, dependent economy, level of employment
Original Article
1 Department of Economics, Krishnagar Government College, Krishnagar, Nadia, West Bengal, India.
2 Department of Economics, Jadavpur University, Kolkata, West Bengal, India.
3 Department of Economics, St. Xavier’s Autonomous College, Kolkata, West Bengal, India.
Corresponding author:
Rilina Basu, Department of Economics, Jadavpur University, Kolkata, West Bengal 700032, India.
E-mail: banerjee.rilina@gmail.com
Foreign Trade Review
57(1) 85–113, 2022
© 2021 Indian Institute of
Foreign Trade
Reprints and permissions:
DOI: 10.1177/00157325211048018
86 Foreign Trade Review 57(1)
In the current pandemic situation, where economies, developed and developing as
well, are at crossroads, the role of the government becomes extremely relevant.
Associated with the enhanced importance of designing appropriate macroeco-
nomic policy and its coordinated implementation are the key issues pertaining to
fiscal policies, which the governments are undertaking to sustain the livelihoods
of the poor by doling out subsidies and grants along with the lump sum expendi-
ture in the development of infrastructure, including the health sector. Given the
unforeseen and uncertain circumstances, the burden on the treasuries cannot be
ignored. This once again brings forth public sector deficits and mounting public
debt as key issues at the heart of macroeconomic policy debate in an open econ-
omy framework. This article addresses the legitimacy of strict adherence to fiscal
discipline, in a situation of crisis, in which symptoms of recovery are not in sight.
Given the importance of fiscal prudence and management in policymaking, this
article is an attempt to provide a theoretical understanding of interaction between
debt dynamics1 and real exchange rate dynamics in the presence of endogenous
risk premium and partial wage indexation in an open economy structure.
There have been numerous questions with regard to fiscal solvency, adequate
monetary policy mechanisms, inflationary tendencies or global and local macro-
economic shocks, which account for a rise in debt-to-GDP ratio. While research-
ers like Masson and Mussa (1995) have pointed out population, inflation and
productivity growth as the main reasons behind worsening fiscal balance sheets
(see Blanchard & Perotti, 2002; Christiano et al., 1999; Fatas & Mihov 2002;
Friedman, 2006; Hasko, 2007; Marcellino, 2006; Melitz, 1995; Mountford &
Uhlig, 2002), others like Burnside (2005) showed that the change in the debt-to-
GDP ratio is the sum of five components: (a) interest payments, (b) the primary
balance, (c) seigniorage, (d) the inflation effect and (e) the growth effect.
The pertinent question is how to sustain such fiscal deficit—by debt financing
or to put additional taxes,2 which in turn may depress demand. This should not be
out of recording that debt in itself might not be a major macroeconomic problem.
However, the issue at stake is utilisation and management of debt.3 The situation
of Argentina and Mexico are excellent case studies in this regard.4 This once again
proved that a prudent mix of policies along with the specific characteristics of the
country and its leadership is essential in the efficient management of debt.
In the Indian context, the Fiscal Responsibility and Budget Management Act
(FRBM Act), 2003, was introduced in line with an extant of literature, which
dwells on aspects of fiscal sustainability that refer to the government’s ability to
maintain its current policies and satisfy its lifetime budget constraint5 without
defaulting on its debt obligations. This has led to repeated analysis and scrutiny of
the long-term profile of fiscal deficit and debt, relative to GDP in India (See
Rangarajan & Srivastava, 2005; Singh & Srinivasan, 2004).
Debt dynamics cannot be isolated from dimensions of openness in general, and
exchange rate in particular. Asonuma (2016) shows that there might be a bidirec-
tional causality between exchange rate dynamics and probability of default, which
depends on the sequence of events. Escude (2002) used multiple theoretical

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