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The limited power of monetary policy in a pandemic

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  • Lepetit, Antoine
  • Fuentes-Albero, Cristina

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.

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  • Lepetit, Antoine & Fuentes-Albero, Cristina, 2022. "The limited power of monetary policy in a pandemic," European Economic Review, Elsevier, vol. 147(C).
    • Handle: RePEc:eee:eecrev:v:147:y:2022:i:c:s0014292122000952
    DOI: 10.1016/j.euroecorev.2022.104168
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    Cited by:

    1. Benmir, Ghassane & Jaccard, Ivan & Vermandel, Gauthier, 2023. "Optimal monetary policy in an estimated SIR model," European Economic Review, Elsevier, vol. 156(C).
    2. Grigoli, Francesco & Pugacheva, Evgenia, 2024. "COVID-19 inflation weights in the UK and Germany," Journal of Macroeconomics, Elsevier, vol. 79(C).
    3. Xiangfa Li & Zhe Zhang & Weixian Xue & Hua Wang, 2022. "The Effects of Household Debt and Oil Price Shocks on Economic Growth in the Shadow of the Pandemic," Sustainability, MDPI, vol. 14(22), pages 1-16, November.
    4. Luca Portoghese & Patrizio Tirelli, 2024. "Getting ready for the next pandemic: supply- side policies to escape the health-vs-economy dilemma," DEM Working Papers Series 219, University of Pavia, Department of Economics and Management.
    5. Trabandt, Mathias, 2023. "Comment on “Optimal monetary policy in an estimated SIR model by G. Benmir, I. Jaccard, and G. Vermandel”," European Economic Review, Elsevier, vol. 158(C).
    6. Pejman Peykani & Mostafa Sargolzaei & Amir Takaloo & Shahla Valizadeh, 2023. "The Effects of Monetary Policy on Macroeconomic Variables through Credit and Balance Sheet Channels: A Dynamic Stochastic General Equilibrium Approach," Sustainability, MDPI, vol. 15(5), pages 1-21, March.

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    More about this item

    Keywords

    COVID-19; SIR macro model; State-dependent effects of monetary policy; Forward guidance; Monetary policy trade-offs; Optimal monetary policy;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E1 - Macroeconomics and Monetary Economics - - General Aggregative Models
    • E11 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Marxian; Sraffian; Kaleckian

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