Monetary Policy and the COVID-19 Inflation Shock

We study the surge in U.S. inflation following the COVID-19 pandemic using a small-scale dynamic general equilibrium model calibrated to the 2020–2024 period. The framework emphasizes the interaction among fiscal transfers, monetary policy, and the government’s intertemporal budget constraint in an economy with heterogeneous households, incomplete insurance and borrowing constraints. We evaluate what monetary policy could realistically have achieved given the observed stance of U.S. fiscal policy. While the model implies that monetary policy was late relative to the optimum, earlier tightening would mainly have altered the timing of inflation rather than the cumulative increase in the price level. More aggressive attempts to smooth the inflation burst through monetary policy alone would have required an unsustainable path for the real interest rate and produced a deep and prolonged recession. We also show that, absent extraordinary fiscal support, the COVID-19 shock would have generated deflationary pressures, binding borrowing constraints and sizable welfare losses for adversely affected households. In this context, the inflation surge of 2021–2022 is best understood as the consequence of large unfunded fiscal transfers implemented in 2020–2021. Although these transfers were likely larger than necessary, they were nonetheless welfare-improving relative to inaction, with the resulting price-level adjustment serving as a second-best means of financing a broadly desirable social insurance response.