The Limited Power of Monetary Policy in a Pandemic

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 ourframework, consumption is less sensitive to real interest changes in a pandemic than in normaltimes because individuals have to balance the benefits of taking advantage of intertemporalsubstitution opportunities with the risk of becoming sick. Accommodative monetary policiessuch as forward guidance result in large increases in inflation but have only limited effects onreal economic activity as long as the risk of infection is large. The optimal design of monetarypolicy hinges on how other tools used to limit virus spread, such as lockdowns, are deployed. Ifthe lockdown policy is conducted optimally, monetary policy should focus on keeping inflation ontarget. However, if the lockdown policy is not optimal, the central bank faces a trade-off betweenits objective of stabilizing inflation and the necessity to minimize the inefficiencies associated withvirus spread.