Covid-19 briefing: post-lockdown macro

Michael Kumhof

In the wake of Covid-19 lockdown, macroeconomic policymakers have to deal not only with the immediate contraction in the economy, but also with the medium and longer term macro-consequences. Over the past four months, the macroeconomic literature on these topics has expanded rapidly. This post reviews the literature that considers the channels via which the shock affects the economy, and the macroeconomic policy options for dealing with the aftermath, taking as given the shock caused by the virus and the lockdown.

Real Flow Variables (Goods Demand and Supply)

Guerrieri, Lorenzoni, Straub and Werning (2020) argue that while the lockdown is originally an (inflationary) negative supply shock because it keeps certain types of business from operating, the balance of the effects can resemble a (deflationary) demand shock under two conditions. The first is demand complementarities between sectors (gym closures that reduce demand for sports clothing), and the second is imperfect insurance (gym instructors who lose income and spend less). Fornaro and Wolf (2020) present a model with supply-demand doom loops driven by animal spirits, and come to similar conclusions. Baquee and Farhi (2020) argue there must also be an aggregate demand shock (e.g. confidence) alongside a supply shock to explain the observed inflation dynamics in the US. However, these arguments rely on models that abstract from the transmission channels of shocks running through balance sheets. This is problematic given the potential for amplification through liability-asset doom loops, bankruptcies and financial contagion. This view is in line with Stiglitz (2015), who argued that reliance on flow-based models, without a role for credit, actually contributed to the 2008 crisis, and to the initially inadequate response in its aftermath.

Balance Sheets (Financial Assets Demand and Supply)

The literature on the effects of the corona crisis on balance sheets is in its infancy. Danielsson, Macrae, Vayanos and Zigrand (2020) argue that the primary channel for a systemic crisis is not amplification from within the financial sector but cascading commercial-sector bankruptcies, and that mitigating these is not the main domain of monetary policy. Perotti (2020) argues that illiquidity in the shadow banking sector is another source of vulnerability by which losses from elsewhere in the economy could spill over to the banking sector. Danielsson, Macrae, Vayanos and Zigrand (2020) argue that banking sectors in major economies are sufficiently resilient to bear those losses, but this is likely to be dependent on the overall size of losses incurred, and on how much of this is borne by the fiscal authority.

Monetary Policy

De Grauwe and Ji (2020) argue that in periods of extreme uncertainty, policy performs better when responding only to current inflation and not to forecasts of inflation, which are bound to be unreliable. While they use a model of animal spirits, this point deserves consideration even for standard central bank DSGE models.

For central banks whose policy rates are already close to zero, Lilley and Rogoff (2020) have recently restated their case for negative policy rates when markets no longer believe that QE is sufficient to maintain inflation at target.  However, the empirical literature, most prominently Heider, Saidi and Schepens (2019), find that commercial banks generally do not push deposit rates to negative levels, so that negative policy rates compress banks’ net interest margins and hence their willingness to lend. This is formalised in the model of Kumhof and Wang (2020), where insufficient willingness to lend implies money creation that is insufficient to support an adequate level of real economic activity.

Fiscal Policy

A small recent literature studies interactions between fiscal policy and interest rate policy. Bianchi, Faccini and Melosi (2020) argue that fiscal and monetary policies cannot be neatly separated, based on the fiscal theory of the price level. The authors propose a separate emergency budget that contains no provisions for long run fiscal balancing, accompanied by a central bank response that tolerates the resulting inflation, which in turn reduces the debt-to-GDP ratio over time. Hagedorn and Mitman (2020) also argue that fiscal and monetary policies cannot be neatly separated, in this case based on HANK (heterogeneous agent New Keynesian) models. They advocate that treasuries should finance spending increases through permanent rather than temporary increases in debt to generate inflation. The policy implications are very similar to Bianchi et al. (2020). An important problem in Hagedorn and Mitman (2020) is the assumption that households are indifferent between IOUs issued by the treasury and the central bank. The problem is that households cannot hold the principal central bank IOU, reserves.

Financing of increased government spending can be based on debt or money issuance. Several recent papers consider variants of debt financing. Goodhart and Needham (2020) argue that the government should issue consols (perpetual bonds) attractive to retail investors, in order to lock in current low interest rates. Similarly, Vihriälä (2020) argues that the ECB should swap existing short-term sovereign debt on its balance sheet against low-interest consols. Corsetti, Erce and Pascual (2020) argue that the European Recovery Fund (ERF) should lend very long term, while financing itself short term to take advantage of even lower short-term interest rates. This would of course not lock in current low interest rates. Bordignon and Tabellini (2020) argue that the ERF should be endowed with genuinely own EU sources of tax revenue.

Debt financing may encounter limits. For the UK, Pacitti, Hughes, Leslie, McCurdy, Smith and Tomlinson (2020) show that if post-corona fiscal policy relies exclusively on borrowing, the larger debt burden creates a vulnerability to a rise in interest rates. For this reason, Gali (2020) has argued for a money-financed fiscal stimulus (“helicopter money”) whereby the central bank lends reserves to the government and then immediately writes off the loan, with the government then spending that money into circulation. Similar arguments are made by Gurkaynak and Lucas (2020), Blanchard and Pisani-Ferry (2020) and Reichlin, Turner and Woodford (2013).

However, one concern with helicopter money, ignored in the papers above, is that new reserve creation needs to be intermediated by the banking system.  It may therefore be necessary to create mechanisms that support helicopter money. One option is to support bank lending, either by ensuring banks have a sufficient net interest margin (NIM) (Kumhof and Wang (2020)), or through other central bank incentives that support bank lending, such as the Bank of England’s Term Funding Scheme. The other option is direct central bank money distributions to non-banks that are not intermediated by banks, as in Friedman (1948). The modern incarnation of this idea is central bank digital currency (CBDC), as in Barrdear and Kumhof (2016). With CBDC, households and firms would directly hold central bank liabilities rather than commercial bank liabilities, and the quantity of these liabilities would therefore be under direct central bank control. Furthermore, CBDC would be interest paying in order to forestall any inflationary effects. One critical advantage of CBDC relative to bank lending is that it would not increase private sector debt and leverage.

Macroprudential Policy

Macroprudential policy could complement monetary and fiscal policies to limit the economic fallout. Drehmann, Farag, Tarashev and Tsatsaronis (2020) summarize the range of tools that are currently available to macroprudential policymakers, and argue that banks should be allowed to use liquidity and capital buffers so they can support lending to the real economy. Aikman (2020) surveys the deployment of these tools around the world so far, including widespread releases of countercyclical capital buffers and more ad hoc relaxation of some other rules. Acharya and Steffen (2020) argue that an extreme drawdown of credit commitments by corporate borrowers could move the Tier 1 ratio of many banks below the regulatory minimum. Regulators should therefore limit dividend payouts or share buybacks. Angeloni (2020) stresses the crucial role of public support for the banking system, including suspension of prudential norms, asset guarantees and public ownership, to facilitate the return to normality for the real economy.


The aftermath of the corona shock will affect many sectors of the economy adversely, and in ways that are not yet easily predictable. However, unlike in the period following the 2008 financial crisis, the most direct effects are likely to occur outside the financial sector. This may account for the fact that a very large part of new research has so far focused on the appropriate design and financing of well-targeted fiscal interventions that help businesses and households. There is nevertheless a significant risk that cascading bankruptcies will ultimately affect the financial sector as well. An integrated response that links fiscal interventions with macroprudential and monetary interventions, including monetary financing interventions, is therefore a high priority for future research.

Michael Kumhof works in the Bank’s Research Hub.

If you want to get in touch, please email us at or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.