How Does Monetary and Fiscal Policy Affect the Economy in the Face of Large Shocks?

We build a model that combines (i) heterogeneous households with incomplete markets, and (ii) state-dependent pricing with strategic complementarities by firms, to analyze the effects of large macroeconomic shocks and policy interventions. Both features significantly influence the transmission of fiscal stimulus and monetary policy—heterogeneous households because of failures of Ricardian equivalence, and state-dependent pricing because of its nonlinear effects on inflation. We use our model to quantify how monetary and fiscal policy shaped macroeconomic dynamics in response to the large shocks of 2020, and how alternative policy choices could have led to different aggregate and distributional outcomes. We find large departures from Ricardian equivalence and strong stepping-on-a-rake effects of interest rate changes. The large unfunded fiscal transfer program helped prevent deflation in 2020 and significantly raised output throughout 2021 and 2022, but led to permanently higher prices. The monetary easing through 2020 and 2021 also contributed to preventing deflation, but had a minimal impact on GDP. The monetary tightening from 2022 lowered the maximum inflation rate, but contributed to persistently above-trend inflation. These policies led to net welfare gains for low-wealth households and net welfare losses for high-wealth households, but those welfare effects are due to incomplete markets for idiosyncratic risk not aggregate stabilization. Alternative commitments to funding fiscal stimulus could have achieved similar short-term effects on inflation and output with a much smaller long-term increase in the price level.