Monetary Policy in the Aftermath of COVID-19

Ruge-Murcia, Francisco | $18,894

Quebec McGill University 2021 SSHRC

The recent COVID‑19 pandemic has had large and extensive humanitarian and economic effects. To date, 230 million people have contracted the disease and 4.7 million have died. Aggressive public health measures accompanied by expansionary fiscal and monetary policies in several countries have limited even more serious consequences of this pandemic. Economic data from many countries show a steep drop in consumption, investment, output, and employment in the first half of 2020 followed by a quick recovery in the second half, yet still below the levels prior to the pandemic. Fiscal policy involved a large increase in government spending in the form of transfers to households and firms leading an increase in its share of gross domestic product that in some countries (e.g., the U.S.) is larger than that observed during the Great Depression in the 1930s. Monetary policy was also expansionary, first by means of interest rate cuts that took the rate close to zero followed by large asset purchases (a.k.a. Quantitative Easing or QE) that have led to exceptional increases in the rate of money growth.

This research proposal is concerned with the implications of the ongoing COVID‑19 pandemic for monetary policy and inflation. An important issue is whether the large increase in monetary aggregates will eventually lead to inflation and, if so, for how long. This research agenda covers four projects. The first project asks how economies respond to extreme shocks, the effectiveness of a large monetary policy response to such a shock, and to what extent persistent inflation may follow or not after this monetary expansion. The second project examines the role of relative price shocks and monetary policy on inflation dynamics before and after the current pandemic. The third project explores whether the composition of central bank asset purchases matters for the effectiveness of unconventional monetary policies. Finally, the fourth project studies what is the optimal exchange rate regime in a small open economy subject to extreme shocks. These projects will be carried out using state-of-the-art modelling and econometric methods and involve the novel use of extreme value theory to model extreme events.

This research is timely and follows in a natural way from my previous (pre-pandemic) work on extreme events and my long-term interest in monetary policy. Results from this research will improve our understanding of the way in which COVID‑19 and other extreme events affect the design and practice of monetary policy. This research will advance knowledge in the field and produce original journal contributions, with codes and replication material made available to other researchers on an open-access basis. Since this research will provide answers to specific policy-relevant questions, it will be helpful to policy makers in central banks and affect the way in which monetary policy is conducted. As such I anticipate that this research will have broader societal benefits as well.

With funding from the Government of Canada

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