Macroeconomic policy in a pandemic era: What does the IS-LM model show?

Abstract

This paper examines how the COVID-19 pandemic will affect macroeconomic policy, setting the dynamics of interest rates in the short to medium term for developed countries and developing (transition) economies. The macroeconomic model of general equilibrium (IS-LM) was chosen as a simple tool for analysis allowing us to identify mechanisms for translating the effects of the pandemic and the corresponding government policy on interest rates. We emphasize the fundamental differences of the situation in the countries that were already in a liquidity trap at the beginning of the pandemic and in the economies still far from this state. The results of the analysis demonstrate the limited effectiveness of monetary policy to restore economic activity in both groups of the countries and the need for fiscal stimulus to reduce uncertainty (or lower the slope of the model curves). Under these conditions, the capacity of debt financing of additional public expenditures, the functioning of the financial sector and ensuring macroprudential stability pose serious problems for economic policy.