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The limited power of monetary policy in a pandemic

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  • Antoine Lepetit
  • Cristina Fuentes-Albero

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.

Suggested Citation

  • Antoine Lepetit & Cristina Fuentes-Albero, 2022. "The limited power of monetary policy in a pandemic," BIS Working Papers 1018, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:1018
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    1. 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.

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    More about this item

    Keywords

    COVID-19; SIR macro model; statedependent 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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