Consumption is less sensitive to real interest rate changes
Lepetit and Fuentes-Albero embed an extension of the classic SIR epidemiological model in a New Keynesian model with uninsurable income risk and evaluate whether monetary policy is as effective in a pandemic as it is in normal times. They find:
- During a pandemic, individuals are less willing to take advantage of intertemporal substitution opportunities since doing so involves a risk of becoming sick;
- The stimulative effects of monetary policy are partially offset by the presence of pro-cyclical income risk: in an attempt to prop up activity, interest rate cuts lead to a build up in the number of new infections (by increasing consumption of face-to-face services) that reinforces the precautionary savings motive and ends up depressing
output;
- As a result accomodative monetary policy in the form of interest rate cuts and forward guidance has only limited effects on real economic activity at the height of a pandemic. It can, however, help sustain the recovery in economic activity once the virus starts dissipating, whether because health interventions keep the number of new infections in check or because the virus has simply run its course.
The Limited Power of Monetary Policy in a Pandemic
Authors: Antoine Lepetit, Cristina Fuentes-Albero
From: Federal Reserve Board
Monetary policy cannot correct pandemic induced distortions
Michael Woodford argues that the COVID-19 pandemic causes the cessation of payments for the activities that need to be shut down and as a result interrupts the flow of payments that would ordinarily be used to finance other activities, even though these latter activities are still socially desirable.
- For example: while it may well be efficient for restaurants or theaters to suspend the supply of their services for a period, the loss of their normal source of revenue may leave them unable to pay their rent; the loss of rental income may then require the real-estate management companies to dismiss their maintenance staff and fail to pay their property taxes; the furloughed maintenance staff may be unable to buy food or pay their own rent, the municipal government that does not receive a normal level of tax revenue may have to lay off city employees, and so on. The later steps in this chain of effects are all suspensions of economic transactions that are in no way required by the need to stop supplying in-restaurant meals and theater performances.
In such an environment of generalized demand failure, economic activity in many sectors of the economy can be much lower than would maximize welfare (even taking into account the public health constraint), and interest-rate policy cannot eliminate the distortions — not because of a limit on the extent to which interest rates can be reduced, but because monetary stimulus fails to stimulate demand of the right sorts. Fiscal transfers are instead well-suited to addressing the fundamental problem, and can under certain circumstances achieve a first-best allocation of resources without any need for a monetary policy response.
Effective Demand Failures and the Limits of Monetary Stabilization Policy
Author: Michael Woodford
From: Columbia University
The cost of a pandemic induced recession
Beraja and Wolf argue that according to standard consumer theory the recovery from a more services-led recession should be weaker than from a similarly deep, more durables-led one. This is because service expenditures declines during a recession do not lead to pent-up demand for this type of consumption in the future, whereas durable expenditures declines do. In this paper, the authors have formalized this argument in a simple general equilibrium model of demand-determined output and documented support for the key model predictions in aggregate U.S. time series data. They used structural and semi-structural approaches to quantify the causal effect of recession demand composition on the strength of the subsequent recovery. Their results suggest that, in present-value output terms, a recession as services-led as that induced by the COVID-19 pandemic in the US will be be around 60 to 100 per cent costlier than a similarly deep, ordinary durables-led US recession.
Demand Composition and the Strength of Recoveries
Authors: Martin Beraja, Christian K. Wolf
From: MIT, University of Chicago
