The COVID-19 Shock and a Fiscal-Monetary Policy Mix in a Monetary Union

Abstract

This paper evaluates the macroeconomic effects of a monetary and fiscal policy mix implemented in a two-region monetary union in response to the COVID-19 shock. The pandemic is modelled as a mix of recessionary demand and supply shocks affecting both regions simultaneously and symmetrically, under two assumptions: the effective lower bound (ELB) constrains the monetary policy rate; and a fraction of households, labelled 'hand-tomouth' (HTM), consume all their available income in every period. The main results are the following: first, higher lump-sum targeted fiscal transfers to HTM households and public consumption spending in one region, financed by issuing public debt, reduce the recessionary effects both domestically and abroad (via the trade channel). Second, the monetary unionwide recession is mitigated more effectively if both regions implement a fiscal expansion and the central bank limits the increase in long-term rates by purchasing sovereign bonds. Third, fiscal measures are less effective if sovereign bond yields increase relatively more in one region because investors perceive its bonds as risky. Effectiveness can be regained if a supranational fiscal authority issues a safe bond.

The fiscal response to the Italian COVID-19 crisis: A counterfactual analysis

“…Our assumption implies that the transmission mechanism of the spillovers is not formalized. Although the role played by spillovers might be important (e.g., Bartocci et al ., 2020 ), this is outside the scope of the present paper, but we are confident that an exact disentanglement of domestic and foreign factors would not significantly affect our main results. 30 As we shall see in the next sections, the measurement of the fiscal response of the Italian Government primarily depends on the overall patterns of the macroeconomic variables and not on the nature of the disturbance triggers.…”

“…Finally, Bartocci et al . (2020) focus on the monetary and fiscal policy interactions in a stylized a two-region monetary union after a pandemic shock, formalized as a mix of recessionary demand and supply simultaneous and symmetric shocks.…”

“…See Altavilla et al . (2020) and Bartocci et al . (2020) for a formal treatment of the ECB response to the COVID-19 crisis.…”

The Fiscal Response to the Italian COVID-19 Crisis: A Counterfactual Analysis

“…18 We allow the response of the central bank in the model to indirectly capture the unconventional monetary policies adopted by the ECB to tackle the pandemic. See Altavilla et al (2020) and Bartocci et al (2020) for a formal treatment of the ECB response to the COVID-19 crisis.…”

“…Finally, Bartocci et al (2020) focus on the monetary and fiscal policy interactions in a stylized a two-region monetary union after a pandemic shock, formalized as a mix of recessionary demand and supply simultaneous and symmetric shocks. In this setup, where an effective-lower bound for monetary policy is also considered, they show that expansive fiscal policies and monetary policies designed to limit the increase in long-term rates by purchasing sovereign bonds are required to effectively mitigate the union-wide recession.…”