The Limited Power of Monetary Policy in a Pandemic

We embed an extension of the canonical epidemiology model in a New Keynesian model with uninsurable income risk. In our framework, two factors contribute to making consumption less sensitive to real interest rate changes in a pandemic. First, individuals are less willing to take advantage of intertemporal substitution opportunities when doing so involves a risk of becoming sick. Second, households face pro-cyclical income risk and a precautionary savings motive tempers their responses to changes in future interest rates. In this context, forward guidance policies have only limited effects on real economic activity at the height of the pandemic. They can, however, help sustain the recovery once the virus starts to dissipate.