DYNAMIC FISCAL POLICIES UNDER KNIGHTIAN UNCERTAINTY: MITIGATING THE ADVERSE EFFECTS OF HOUSEHOLD DEBT ON ECONOMIC STABILITY—A NARRATIVE REVIEW

Abstract

The significance of the vulnerability of the household sector as a major source of macroeconomic vulnerability has come to the fore. This is particularly true when the uncertainty setting is Knightian, in which the distribution of shocks is not well known at best. Too much domestic debt can suppress private spending and can make downturns worse; traditional static or discretionary fiscal policy can slow down aggregate demand growth due to the inelasticity of precautionary saving and the ambiguity aversion. In this narrative review, we roll up 18 studies from 2010 to 2026 and included in Scopus to develop a new combined framework of the connection between household debt vulnerability and Knightian uncertainty and dynamic, state-contingent fiscal policy. The paper critically summarises the existing multidisciplinary literature from 2010 onwards and assesses the literature's understanding of the usefulness of dynamic, state-contingent fiscal policies to reduce household debt vulnerabilities and boost macroeconomic resilience in the presence of deep uncertainty. The synthesis shows that the stress on the household balance sheet tends to have a non-linear effect on fiscal transmission mechanisms across the four themes of this study: precautionary behaviour and demand suppression, Knightian uncertainty in decision-making, dynamic fiscal rules vs discretion and integrated policy coordination. The literature reviewed suggests austerity is not effective in the context of austerity. In contrast, automatic activation triggers of state-contingent fiscal transfers will lead to a more stable expectation of households and bring the multiplier effect back. Moreover, the greatest stabilization effects are achieved if the dynamic fiscal measures are coupled with monetary easing and countercyclical macroprudential caps. This paper collectively, conceptually, brings together results of various strands of the studies on macro-finance, public economics and behavioural studies, thereby synthesizing theoretical extensions to the standard rational expectations paradigm. It also provides practical recommendations for adaptive rule-based stabilization regimes which can withstand risks to the balance sheets in a very volatile economic environment.