September 24, 2020

Macro Series

Aggregate demand policy in a time of COVID

BY Silja Sepping, John Llewellyn, Russell Jones

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Report Contents

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( 21 mins)
  • Large increases in government expenditure generally necessitate restraint elsewhere
  • However at present significant resources are lying idle: no such sacrifice is needed
  • Hence increases in government exenditure currently need not be financed by borrowing
  • Neither need they be recorded as increases in debt owed to the public
  • Today’s circumstances require the explicit coordination of fiscal and monetary policy
  • This could be calibrated by targeting an appropriate target path for nominal GDP

You wouldn’t want to start from here

The world is faced by a major macro policy conundrum

The COVID-19 pandemic and its aftermath pose two fundamental and closely-related challenges to macro stabilisation policy: to specify the framework most appropriate for these novel and difficult circumstances; and to determine appropriate operational procedures.

In this Focus we go back to first principles to consider how, in our judgement, policymakers might best respond to what is an unprecedentedly sharp recession, in which the likelihood is that economic activity worldwide will take some years to return to its previous peak, let alone its prior extrapolated trend. In particular, how should fiscal and monetary policy operate?

In a deep hole

These are not normal times

Much of the time, resources in the aggregate are relatively scarce, 1 in the sense that it is not possible, in the near term, for an economy to produce substantially more than it is already doing: economies typically operate reasonably close to full capacity.

There is a cavernous and likely enduring output gap

The current environment, however, is different. Notwithstanding a relatively strong rebound in real activity when initial stringent pandemic-related lockdowns were eased, macro resource utilisation rates remain highly depressed. In most countries, whether because of government decree or individuals’ decisions, substantial portions of the workforce and of the capital stock are idle. Moreover, many other people and companies continue to work short hours, and suffer reduced employment or income.

Furthermore, with COVID infection rates again increasing, and no vaccine yet available, the risk is of a hesitant and uneven recovery, if not of further significant setbacks to growth and employment.

Huge fiscal stimulus has been aimed at sustaining incomes …

In these exceptional circumstances, most governments have felt, and many continue to feel, a need directly to support the purchasing power of those who have suddenly lost part or all of their income. This has been reflected in a fiscal expansion on a scale unprecedented in peacetime. The IMF reports that the G-20 economies collectively have already eased budgetary policy by some 12 percentage points of GDP. 2 The need for large-scale fiscal support is likely to continue until recovery becomes self-sustaining.

Following the events of 2008, increasingly arcane monetary measures – quantitative easing, statedependent forward guidance, and negative interest rates, to name but three – warded off what would otherwise have probably been an even deeper recession. But with fiscal policy working at cross-purposes from 2010, self-sustaining recovery was not achieved.

… and it will have to remain the primary policy support


With the added blow to confidence caused by COVID-19, it now seems even more unlikely that monetary policy alone can do the job of re-energising the world economy. Fiscal policy will perforce have to shoulder much of the responsibility, and it will have to be applied in a more sustained and determined manner than it was in the wake of the previous recession. 3

How therefore to manage this fiscal support?

Funding government expenditure

But how it should be applied is open to debate

When circumstances are particularly unusual, it pays to look critically at whether it makes sense to operate within the confines of the conventional wisdom, or whether a different approach is warranted. It can also be wise to look to the past for inspiration.

Normally, if government wants to increase its own absorption of resources, or enable some sections of society to increase theirs, it has to reduce the absorption of others. It can achieve this only through taxation, or borrowing, whether from domestic residents or from foreigners.

(Similarly, in a dynamic context, it has to ensure that the growth of its spending is persistently not out of line with the feasible growth of the economy.)

If, in normal times, government were to violate this principle, the result would be excess demand and upward pressure on the price level, whether directly through increased pressure on domestic resources; indirectly through depreciation of the currency; or, most likely, a combination of the two.

Such is the likely lasting degree of excess capacity …

However, with so many resources currently lying idle, governments can increase their expenditure without the need to divert labour and capital from other uses. It is therefore in no way necessary to oblige (through taxation) or induce (by borrowing) others to absorb less; i.e. it is in no sense necessary for government to raise taxes or to borrow from anyone; and hence there is no need for it to incur any obligation to repay anything to anyone in the future.

Accounting for government expenditure

… that outright monetary finance becomes applicable

Consequently, there is no requirement, in present circumstances, for the additional government expenditure to be added to the figure for the national debt, 4 nor to commit future taxpayers to making interest payments to bond-holders. The government can simply pay for the requisite expenditure with increased money issuance.

This boasts an impressive intellectual lineage …

The notion that government has, in extreme circumstances of underutilised resources, the option simply to ‘create money’, ‘print money’, or engage in ‘monetary finance’ – three commonly-used phrases – is scarcely new, having been advanced by a range of celebrated economists, including Fisher, Simon, Keynes, Meade, Tobin, Friedman, Buiter, Sims, Bernanke and Turner. 5 Most famously perhaps, and certainly particularly cogently, it was advanced nearly eighty years ago by Abba Lerner in his seminal 1943 paper on ‘Functional Finance’. 6

… that dates from far before modern monetary theorists …

Periodically this old wine is put into new bottles, most recently under the label of (so-called) Modern Monetary Theory (MMT). 7 In its academic form, MMT is close to that of Lerner, 8 although – as happens with almost any theory – some populist supporters take it to an extreme, arguing that government can finance any expenditure that it chooses, regardless of circumstance. 9 This is a perversion of the basic logic.

… but it should be employed only after careful consideration

All sensible commentators acknowledge that, most of the time, government is subject to real resource constraints. Hence before deciding whether, or to what extent, exceptionally to engage in monetary financing, it is necessary to consider a range of issues – and three in particular.

Three key objections and potential problems

Demand expansion can easily become excessive …

The first issue is that, when the government ‘writes cheques drawn on the central bank’, these will in due course come back to the central bank in the form of commercial bank reserves. Those reserves in principle enable the banks to increase the credit that they extend without themselves having to borrow; and this could, in theory, facilitate a further, secondary, expansion of demand and the money supply, and at a time when that might be inappropriate.

This risk can, however, be controlled by the central bank’s normal policy instruments. The central bank can raise short-term interest rates to discourage credit demand; it can tighten commercial banks’ reserve requirements to sterilise the excess liquidity; or, indeed, it can do both.

… so it is vital that spending power be withdrawn if necessary

Second, while a government does not need to ‘finance’ its expenditure in the conventional sense that a business firm does, it does have the responsibility for balancing, not overloading, the economy. Thus while, in the present unprecedented circumstances, government can buy what it wants simply by writing a cheque on the central bank, thereby creating money, it will in all likelihood have to withdraw spending power from the economy, by borrowing or raising taxes, when the economy nears capacity limits and excess demand and inflation threaten.

There can also be a problem of perverse incentives for politicians

A third concern – and potentially perhaps the most serious – is that to exercise, and thereby legitimise, the ‘money printing’ option is to risk opening a Pandora’s box, such that politicians, seeing themselves as having been freed of the shackles of budgetary constraint, continue to spend excessively even when the economy is back to near-full capacity. This, after all, is a lesson of history. 10 Fears of such considerations, together with a general sense that the new regime was profligate and risky, could also hurt private sector confidence, rendering the process of macro stabilisation even harder.

Transparent policy rules and oversight are thus imperative

Thus it is essential, if monetary financing is to be applied appropriately, that there be both the requisite institutional arrangements to effect it, and adequate checks and balances to prevent its excessive use.

Current institutional responsibilities

Policy frameworks have always evolved

Macroeconomic institutional arrangements and their operation are a product of domestic constitutional organization and historical experience; and in changing circumstances they may not always remain appropriate.

This in part reflects US intellectual and broader hegemony …

For some time, so-called ‘independent’ central banks have been accorded the dominant role in macro stabilisation, with a particular focus on the control of goods and service price inflation, using monetary policy instruments. Other goals, including maintaining employment incomes and financial stability have in many cases been relegated.

… with fiscal policy playing only a secondary role

Fiscal policy, by contrast, has come to be seen essentially as a tool suited more to resource allocation than to active demand management. Beyond allowing the automatic stabilisers to function (and, largely for political reasons, these differ considerably in potency from country to country), counter-cyclical fiscal policy has been frowned upon except briefly in deep recessions and financial crises.

This in part reflects US intellectual and broader hegemony …

To some extent these policy biases reflect the dominance of the United States in world economic literature and thinking. One consequence of the US division of constitutional powers is that the executive does not control fiscal policy reliably. And certainly it is often unable to act quickly, given that budgetary measures have to pass through Congress, which may have a different political complexion from that of the President. Counter-cyclical fiscal policy is therefore hardly possible.

… as well as the nature of particular political systems …

In Parliamentary systems that particular problem does not arise. Even there, the inevitable informational, planning, and logistical lags in discretionary fiscal policymaking can all too easily result in its proving pro-, rather than counter-, cyclical. That said, the technical difficulties facing fiscal policy are no greater than those facing monetary policy when used counter -cyclically. The lags in recognising the state of the economy , and the further lags in the operation of policy , are significant in both cases. Few today believe that an activist fine-tuning of demand is sensible: counter-cyclical policy should be confined to offsetting substantial shocks. 11

In the EU, fiscal-monetary co-ordination is problematic because the two arms of macro policy are conducted at different levels of government, and the requisite institutional arrangements, including importantly the establishment of sufficient centrally-controlled fiscal firepower, have not yet been put in place.

… and a tendency to go on fighting the last policy battle

Beyond these institutional considerations, the dominance of monetary policy over the past several decades is also a legacy of the extended late 1960s to early 1980s battle against high inflation. 12 This was a searing experience for policymakers, and it remains with them to this day.

All that said, however, runaway inflation has scarcely been the problem since 1990. The inability of the U.S. Federal Reserve in the 2000s to raise bond yields, even when it tried to do so with higher short-term rates, showed that markets had become convinced that inflation would remain low far into the future. Moreover, the fundamental signal from near-zero inflation and nominal interest rates since 2008 has been that aggregate demand, far from being excessive in relation to aggregate supply, has in fact been deficient. 13

One thing is clear: restraint should no longer be the priority

Nowadays, therefore, aggregate demand policy has to be concerned as much with stimulus as with restraint, and indeed had to be so even before COVID-19; the coordination of fiscal and monetary policy is perforce back on the agenda.

Brave new world

Satisfactory monetary-fiscal coordination requires:

  • Appropriate institutional arrangements for the conduct of the two policies taken together; and
  • Clear specification of both the circumstances in which it is appropriate to engage in monetary finance; and those that, once met, should cause it to be curtailed.

Institutional arrangements

Central banks for their part could well welcome government deficits as a more efficient route to achieving the results that they seek from expanding their balance sheets: 14 people experience the monetary finance of government expenditure as an income flow, and this can be expected to be more effective in promoting economic activity than is quantitative easing, which people experience merely as a change in the term structure of their assets. From the perspective of central banks, financing of government expenditure stands to offer a bigger ‘bang’ for the balance sheet buck.

The nature of central bank independence may have to change

That said, neither the central banks nor many other groups in society would wish central banks to lose their much-vaunted independence. Fortunately, efficient monetary-fiscal coordination need not require this.

In particular, independence is not jeopardised by the central bank taking in government bonds directly, provided that it has the free use of its own policy instruments and the right to resell government bonds on the open market when it eventually judges it necessary to reduce the money supply and damp demand: 15 it is not how the central bank acquires government bonds that matters, but rather that it retains the right to sell them at its own discretion. 16

But central banks must retain control over the timing of bond sales

One issue, however, is that once a central bank engages in buying and selling longer-term government bonds it starts to cut across the operations of the government’s debt management function: new protocols have to be established. One possibility would be for the institution responsible for debt management to decide what bonds the government issues, which then can be issued to the central bank. The central bank would however have the final say on which bonds to hold on its balance sheet and which ones to sell on to the public.

Specification of conditions has to be transparent …

Specification of circumstances

While it is accepted in many , perhaps most, advanced economies that responsibility for economic management rests ultimately with elected governments, it is equally recognised – in principle if not always in practice – that the technocratic achievement of government-specified targets is best left to bodies that are operationally independent.

Nowhere is this more important than in the case of monetary financing of government expenditure. Here it is essential that it be a robustly autonomous, statutorily protected, body that determines, on the basis of a full and balanced assessment of all the evidence, when the conditions have been met for such financing to be undertaken and – equally importantly – for it to be ended.

And might warrant an appropriate dedicated body

Respected and trusted central banks could be charged with this reponsibility. Alternatively, a special-purpose agency could be charged with it. The UK’s Office of Budgetary Responsibility is one such model.

Addressing the conjuncture

Structural change has accelerated …

Determining when monetary financing should cease is not straightforward after a substantial shock to the pattern as well as the level of demnd. Post-COVID-19 there will probably have been significant changes in patterns of demand, affecting what is produced and, quite probably, where it is produced. This will lead to at least some of the existing capital stock being scrapped, as no longer economically viable – cruise ships, convention centres, some office buildings, long-haul aircraft, for example. Meanwhile, gross fixed capital formation too will have been hit hard typically it is one of the components of demand that suffers most in a recession.

… while investment has fallen sharply

The policymaking challenge will therefore be two-fold:

Policy must not just fill a hole, but also build a launching pad …

  • To deliver persistent stimulus until the economy expands to the point where it can no longer bring idle capacity back into use – by which time, it is to be hoped, private sector optimism will be returning, and entrepreneurs will be starting to add to capacity to meet expected continually growing demand; and
  • Deciding when the moment has been reached that government deficits should be reduced, or offset by the selling of bonds.

… and then be agile enough to prevent excess demand

Calibrating policy: targeting nominal GDP

One way in which policy could be calibrated – and particularly usefully in times of a supply shock would be to target nominal GDP growth. 17 Both monetary and fiscal policy operate at current prices; they affect nominal magnitudes. The split of nominal GDP growth into price inflation and real growth is determined principally on the supply side of the economy, and is not affected much by demand management.

One option would be to target nominal GDP growth…

Ideally, the target would be a matter for national debate and decision. Short of that, it would seem reasonable to suggest that, over the long term, in most advanced economies real growth of (say) 1½ to 2% per year should be feasible; and that an inflation rate of (say) 2%, as is generally the case today, would be acceptable. Hence, a nominal growth target of around 4% would seem plausible and sensible.

Such a yardstick shows up clearly the inadequacy of the economic performance of the advanced (G7) countries following the Global Financial Crisis. Nominal GDP growth from 2008 to 2019 for the G7 aggregate of countries fell well short of 4% over the period taken as a whole – see Figure 1. Moreover, it fell short fairly systematically throughout – see the quarterly changes data in Figure 2.

Were performance to be monitored against a nominal GDP-growth yardstick, it would throw emerging performance issues into sharper relief. To the extent that the supply side was responsive, much of the growth of nominal GDP would be of real output, rather that of the price level. That would be welcome. To the extent, however, that the supply side was not particularly responsive, the bulk of the growth of nominal GDP would be manifested as a rise in the aggregate price level. This would be unwelcome, and would suggest two possible responses:

… albeit in a flexible manner

  • Directing policy at improving the responsiveness of the supply side via a programme of structural reform; or, to the extent that that could not be achieved,
  • Reducing the nominal GDP growth target.18

Some initial flexibility

Some flexibility would, however, be necessary in the early stages of recovery.

…Some over-shooting could be accepted if real growth were rapid …

In the transition to the longer run, the authorities should probably accept overshoots of the nominal GDP growth target where they were driven by real growth. Were, for example, real output to grow by 4%, and the price level by 2%, making for a growth of nominal GDP of 6%, this would in and of itself be no cause for alarm.

… but only until conditions became more normal

It is difficult to predict the residual degree of slack in an economy, and hence the period for which such above-trend growth might prove possible. As time and recovery progresses, however, there would be a need for greater vigilance. When data on labour vacancies, physical capacity utilisation, wages and prices suggest that the transition was coming to an end, it would be time to embrace a stricter application of the target.

The whole process of policy calibration could be helped by encouraging the development of a nominal GDP futures market. It could provide an additional compass for policymakers in a similar manner to market-determined inflation-expectations.

Aggregate demand policy in a time of COVID 1

None of this is to suggest that nominal income alone can provide sufficient information for economic management: but this approach can prove useful in drawing the two crucial issues growth and inflation – into joint consideration.

The risks

Governments need to escape from the tyranny of debt …

There are risks to changing any policy regime, but there is also risk in not adapting policy to changed circumstances. Indeed arguably one of the greatest threats in the coming several years is that countries become alarmed at the figure that they record for the excess of Government expenditure over receipts during the COVID-19 crisis; that they regard that as an (increase in) the public sector debt burden that has to be reduced; and that they start to tighten the stance of aggregate demand policy before economies have re-attained what would otherwise have become a sustainable rate of growth with acceptable inflation.

… and worry only with the public debt that is held in private hands

It is important that the government be concerned only with its debt in private hands. The point of monetary financing is partly lost if the government obsesses about its debt held at the central bank. That is, at most, a contingent liability which eventuates only if the central bank sells it in the secondary market. That eventuality seems remote – and particularly so at present. 19

Early reversion to post GFC type austerity would be folly

For government to have its actions determined by the amount of its debt held by the central bank would be to repeat the policy error following the 2008 Global Financial Crisis when, after providing fiscal support of the order of 2% of GDP for two years or so, many countries then reversed that policy stance in what proved to be a (largely self-defeating) attempt to reduce public sector debt.

Summary and conclusions

In the current circumstances of widespread excess capacity there is no a priori need to finance government expenditure via bond issuance or tax increases. Instead it can be done in important part by monetary finance. This expenditure need not be recorded in the figure for the national debt – in the sense of money owed by the government to the private sector.

This prescription will change, however, as and when conditions return to near-normal levels of unemployment and broader resource utilisation. Embracing monetary finance as a primary macro stabilisation tool requires close co-ordination by the monetary and fiscal authorities, and might need to be accompanied by significant institutional change. Such financing would need to be undertaken within specified boundaries, and the conditions would have to be monitored closely and transparently by a respected independent institution. Monitoring the evolution of nominal GDP relative to a (say) 4% growth target could be one appropriate operational tool.

Not all countries will manage the present challenge equally well: the relative success, or failure, of individual country policymakers may prove to be one of the most important differentiators of their relative economic and financial performance, as well as of their social and political evolution.

Aggregate demand policy in a time of COVID 2

It is too soon to guess which countries will basically succeed, and which will fail. But it will be one of the dimensions of policymaking that we, for one, will be monitoring and judging particularly closely in the months and quarters ahead.

Watch fors

  • The extent to which individual countries do, or do not, record their ‘excess’ COVID-19-related expenditure as an increase in the public debt.
  • National public debates about whether these expenditures represent borrowings that have to be ’repaid’ by tightening fiscal policy.
  • The evolution of nominal GDP and, in particular, its real component, which represents the ultimate underpinning for asset market valuations.
  • Evolving market expectations of output and inflation.
  • Unduly pre-emptive tightening of policy.
  • A poor growth and inflation trade-off, and how it is tackled.

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