The limited power of monetary policy in a pandemic

Antoine Lepetit and Cristina Fuentes-Albero

European Economic Review, 2022, vol. 147, issue C

Abstract: We embed an extension of the canonical epidemiology model in a New Keynesian model and analyze the role of monetary policy as a virus spreads and triggers a sizable recession. In our framework, consumption is less sensitive to real interest changes in a pandemic than in normal times because individuals have to balance the benefits of taking advantage of intertemporal substitution opportunities with the risk of becoming sick. Accommodative monetary policies such as forward guidance result in large increases in inflation but have only limited effects on real economic activity as long as the risk of infection is large. The optimal design of monetary policy hinges on how other tools used to limit virus spread, such as lockdowns, are deployed. If the lockdown policy is conducted optimally, monetary policy should focus on keeping inflation on target. However, if the lockdown policy is not optimal, the central bank faces a trade-off between its objective of stabilizing inflation and the necessity to minimize the inefficiencies associated with virus spread.

Keywords: COVID-19; SIR macro model; State-dependent effects of monetary policy; Forward guidance; Monetary policy trade-offs; Optimal monetary policy (search for similar items in EconPapers)
JEL-codes: E1 E11 E5 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:147:y:2022:i:c:s0014292122000952

DOI: 10.1016/j.euroecorev.2022.104168

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