VoxEU Column COVID-19 Macroeconomic policy Monetary Policy

How to pay for the (pandemic) war

Fighting the consequences of the COVID-19 pandemic poses a difficult task for fiscal and monetary authorities alike. The current low interest rate environment limits the tools of central banks while the record high debt levels curtail the efficacy of fiscal interventions. This column proposes a coordinated policy strategy aiming at creating a controlled rise of inflation and an increase in fiscal space in response to the COVID-19 shock. The strategy consists of the fiscal authority introducing an emergency budget while the monetary authority tolerates an increase in inflation to accommodate this emergency budget.

The COVID-19 pandemic found policymakers facing constraints on their ability to react to an exceptionally large recession. The current low interest rate environment limits the tools the Federal Reserve can use to stabilize the economy and correct a prolonged period of below-target inflation. The record high debt level entering the pandemic could curtail the efficacy of fiscal interventions by inducing expectations of costly fiscal adjustments. The recent fiscal stimulus of $2.6 trillion and the recession caused by the restrictive measures taken by authorities in many states to combat the spreading of COVID-19 are adding to an already strained fiscal situation. The debate over the consequences of widening fiscal imbalances is moving toward the centre of the political agenda at a time in which expansionary fiscal measures are of primary importance to minimize the long-run damages of the COVID-19 pandemic.1

Union is strength: The emergency budget strategy

We study a way around this dilemma through a coordinated strategy between the monetary and fiscal authorities to stabilize the fraction of the large public debt that results from the recent fiscal stimulus.2 Under the coordinated strategy, the fiscal authority ascribes the fiscal interventions in response to the COVID-19 pandemic to an emergency budget for which no provisions are made for how it will be balanced, while the Federal Reserve adopts a temporary increase of the inflation target to accommodate the inflationary pressure owing to the emergency budget. The coordinated policy allows the fiscal authority to enhance the effectiveness of the fiscal stimulus and the central bank to correct a two-decade-long period of below-target inflation. Thus, the coordinated strategy provides an escape from the limited leeway that the fiscal and monetary authorities face when acting in isolation. At the same time, the policy proposal preserves long-run central bank independence by delimitating the amount of debt that requires a central bank intervention.

To understand the key mechanism behind the policy proposal, consider that in general equilibrium models, the central bank is able to control inflation only under the assumption that the fiscal authority is committed to stabilize debt. When this assumption is relaxed, fiscal imbalances generate inflationary pressure and economic expansions if agents expect that the monetary authority will keep real interest rates low to alleviate the fiscal burden. In our model, the regular budget is fully backed by future primary surpluses, but the emergency budget is not. The central bank allows just enough inflation to stabilize this portion of the overall fiscal burden.

President Roosevelt's New Deal provides an important historical precedent that shares some similarities with our approach. In 1933, President Roosevelt openly argued that there were two separate budgets. A regular federal budget for which a pledge was made to cut specific outlays to guarantee its fiscal backing, and an unbalanced emergency budget. The same year, the United States abandoned the gold standard, reclaiming autonomous monetary policy. The combination of the two policies arguably played a key role in ending the Great Depression.

Effects of fiscal stimulus greatly amplified

We introduce the notion of emergency budget into an otherwise state-of-the-art new-Keynesian dynamic general equilibrium model to illustrate the effects of adopting the coordinated policy strategy with respect to the COVID-19 fiscal stimulus. The model features a rich fiscal block with distortionary taxation. Unlike a typical model, the fiscal authority has two budgets: A regular budget and an emergency budget. The fiscal authority is committed to cover the debt ascribed to the regular budget following the orthodox approach --by raising primary surpluses. Yet, the fiscal and monetary authorities agree on working together to stabilize the emergency budget resulting from the $2.6 trillion stimulus package. The central bank introduces a short-term inflation goal which clarifies that the monetary authority is willing to cooperate with the fiscal authority. The concerted actions of the two authorities make such a path for inflation credible because it is needed to stabilize the emergency budget.

Figure 1 illustrates that this new setting causes a rapid stabilization of the debt-to-GDP ratio mainly because it lifts economic activity persistently. Even though the $2.6 trillion 2020 stimulus bill is the largest U.S. fiscal stimulus on record, the decision of ascribing it to the emergency budget results in just a modest increase in inflation. A general equilibrium effect explains this result. The emergency budget generates inflationary pressure that the central bank accommodates, lowering the real interest rate and improving the ability of policymakers to shore up the economy from the COVID-19-recession. The resulting economic expansion significantly contributes to lowering the debt-to-GDP ratio and the increase in inflation necessary to wear away the emergency budget. Indeed, after a rapid but contained increase, inflation falls again but remains slightly heightened for several years. Such a persistent effect on inflation raises nominal interest rates and reduces the risk for the economy to fall into a liquidity trap.

Figure 1 Transitional dynamics of key macroeconomic aggregates: fiscal orthodoxy vs. emergency budget

Note: Under the fiscal orthodoxy scenario (black dashed line), the entirety of the debt-to-GDP ratio is stabilized by the fiscal authority. In the emergency budget scenario (solid blue line), the COVID-19 fiscal stimulus is assigned to an emergency budget with no fiscal backing

Figure 2 illustrates how the monetary and fiscal authorities can implement the emergency budget to respond to the COVID-19 pandemic. The right plot shows the actual behaviour of the debt-to-GDP ratio (solid blue line), together with the debt-to-GDP ratio which the fiscal authority is committed to cover with future fiscal adjustments (red dashed-dotted line). The difference between the two lines corresponds to the emergency budget. The left panel of Figure 2 shows actual inflation (solid blue line) along with the announced time-varying target (dotted-dashed red line), which reflects the inflation needed to stabilize the share of the debt-to-GDP ratio imputed to the emergency budget.

Figure 2 Monetary and fiscal policy targets under an emergency budget

Note:  Under the emergency budget scenario, the COVID-19 fiscal stimulus is ascribed to an emergency budget with no fiscal backing. The emergency budget is given by the difference between the total debt-to-GDP ratio (solid blue line) and the amount of debt-to-GDP ratio backed by future primary surpluses (dashed-dotted red line). The red dashed-dotted line in the left panel corresponds to the temporary state-dependent inflation target.

Inaction is not an option

Inaction may lead to two equally unpalatable outcomes: fiscal orthodoxy and loss of central bank independence. In the fiscal orthodoxy scenario, policymakers follow the orthodox approach of raising taxes and cutting expenditures to reduce the debt-to-GDP ratio. The black-dashed line in Figure 1 shows that the orthodox approach dwarfs the expansionary effects of the fiscal stimulus on output and has very long-lasting contractionary effects. This economic slowdown partially defies the government's effort to reduce the debt-to-GDP ratio, resulting in a much longer period of fiscal consolidation compared to the emergency budget strategy.

In light of this grim outcome, the fiscal authority might become unwilling to rein in debt via fiscal adjustments and coerce the central bank to create inflation to stabilize the entirety of debt. As illustrated in Table 1, the loss of central bank independence implies a drastic increase in macroeconomic volatility with respect to fiscal orthodoxy because the monetary authority is supposed to accommodate all fluctuations in the debt-to-GDP ratio. Instead, the emergency budget strategy preserves long-run macroeconomic stability by delimitating the amount of debt that requires the intervention of the monetary authority.

Table 1 Macroeconomic volatility across policy scenarios

Note:  Unconditional standard deviation of inflation and output under the assumption that the fiscal and monetary policy mix is: (1) monetary-led (fiscal orthodoxy); (2) coordinated over an emergency budget (emergency budget); (3) fiscally-led (lost Central Bank independence).

Emergency budgets as automatic stabilizers

Policymakers could also announce that they will systematically use the emergency budget framework during those recessions that are large enough to push the economy to the zero lower bound by ascribing the corresponding expenses to the emergency budget.3 In this case, the emergency budget would act as an automatic stabilizer, increasing inflation expectations every time the economy is at risk of falling into a liquidity trap. The increase in inflation expectations would determine a drop in the real interest rate and, consequently, a smaller recession and no deflation. Thus, the emergency budget would compensate the limits of monetary policy in a low interest rate environment and reduce the overall volatility of the economy in response to very large shocks.


We analysed a coordinated fiscal and monetary strategy aiming at creating a controlled rise of inflation and an increase in fiscal space in response to the COVID-19 shock. The policy proposal alleviates the constraints currently faced by the two authorities. The coordinated strategy enhances the efficacy of the fiscal stimulus planned in response to the COVID-19 pandemic, generates only moderate levels of inflation, and preserves long-run macroeconomic stability by separating long-run fiscal sustainability from a short-run policy intervention.

A coordinated action that delimits the amount of debt that requires central bank intervention may be the lesser of two evils for those concerned about preserving central bank independence. In fact, the coordinated strategy might be even desirable in and of itself because it would bring about a controlled reflation of the US economy, rendering the Federal Reserve the necessary room of manoeuvre to stabilize the economy in the years ahead.

Authors’ note: The views in this column are solely those of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of Chicago, Danmarks Nationalbank, or any person associated with the Federal Reserve System or the European System of Central Banks.


Baldwin, R (2020), “Keeping the Lights On: Economic Medicine for a Medical Shock,”, 13 March.

Blanchard, O (2020), “Is there deflation or inflation in our future?”,, 24 April.

Blanchard, O and Pisani-Ferry, J (2020), “Monetisation: Do not panic”,, 10 April.

Bianchi, F, R Faccini and L Melosi (2020), “Monetary and Fiscal Policies in Times of Large Debt: Unity is Strength”, CEPR discussion paper 14720.

Bianchi, F and L Melosi (2019), “The Dire Effects of the Lack of Monetary and Fiscal Coordination”, Journal of Monetary Economics 104: 1-22.

Galí, J (2020), “Helicopter money: the time is now,”, 17 March.

Yashiv, E (2020), "Breaking the taboo: the political economy of COVID-19-motivated helicopter drops",, 26 March.


1 See Baldwin (2020) for a discussion of the importance of using policy interventions to reduce the persistence of the crisis and avoid the unnecessary accumulation of “economic scar tissue”. See also related articles by Blanchard (2020), Blanchard and Pisani-Ferry (2020), Galí (2020), and Yashiv (2020).

2 See Bianchi et al. (2020) for a detailed and complete analysis of the emergency budget strategy presented in this article.

3 See Bianchi and Melosi (2019) for a discussion of how a similar policy can be used to avoid the zero lower bound and resolve conflicts between the monetary and fiscal authorities.

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