Forward Guidance And The State Of The Economy

This paper examines the economic effects of forward guidance using a New Keynesian model with a zero lower bound (ZLB) constraint on the short-term nominal interest rate. Forward guidance is modeled with anticipated news shocks to the monetary policy rule. There are five key findings: (1) the stimulative effect of forward guidance falls as the economy deteriorates or as households expect a slower recovery because there is a smaller margin to lower expected policy rates; (2) longer forward guidance horizons do not generate increasingly larger impact effects on output when the total amount of news is fixed, unlike with an exogenous interest rate peg; (3) in steady state, an unanticipated shock has a larger impact effect on output than a news shock, but a news shock has a larger cumulative effect in every state of the economy; (4) at the ZLB, the cumulative effect on output from lengthening the forward guidance horizon increases over short horizons but decreases thereafter, which indicates the central bank faces limits on how far forward guidance can extend into the future and continue to add stimulus; and (5) forward guidance is stimulative in the absence of other shocks, but the observed effect on output is smaller or even negative if another shock simultaneously reduces demand.(This abstract was borrowed from another version of this item.)