A theory of fiscal policy response to an epidemic

Governments worldwide have issued massive amounts of debt to inject fiscal stimulus during the COVID‐19 pandemic. This paper analyzes fiscal responses to an epidemic, in which interactions at work increase the risk of disease and mortality. Fiscal policies, which are designed to borrow against the future and provide transfers to individuals suffering economic hardship, can facilitate consumption smoothing while reduce hours worked and hence mitigate infections. We examine the optimal fiscal policy and characterize the condition under which fiscal policy improves social welfare. We then extend the model analyzing the static and dynamic pecuniary externalities under scale economies—the decrease in labor supply during the epidemic lowers the contemporaneous average wage rate while enhances the post‐epidemic workforce health and productivity. We suggest that fiscal policy may not work effectively unless the government coordinates working time, and the optimal size of public debt is affected by production technology and disease severity and transmissibility.