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Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound

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  • Levin, Andrew
  • López-Salido, J David
  • Nelson, Edward
  • Yun, Tack

Abstract

The recent literature on monetary policy in the presence of a zero lower bound on interest rates has shown that forward guidance regarding the path of interest rates can be very effective in preserving macroeconomic stability in the face of a contractionary demand shock; moreover, that literature apparently leaves little scope for any further improvements in stabilization performance via nontraditional monetary policies. In this paper, we characterize optimal policy under commitment in a prototypical New Keynesian model and examine whether those conclusions are sensitive to the specification of the shock process and to the interest elasticity of aggregate demand. Although forward guidance is effective in offsetting natural rate shocks of moderate size and persistence, we find that the macroeconomic outcomes are much less appealing for larger and more persistent shocks, especially when the interest elasticity parameter is set to values widely used in the literature. Thus, while forward guidance could be sufficient for mitigating the effects of a 'Great Moderation'-style shock, a combination of forward guidance and other monetary policy measures - such as large-scale asset purchases - might well be called for in responding to a 'Great Recession'-style shock.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7581.

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Date of creation: Nov 2009
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Handle: RePEc:cpr:ceprdp:7581

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Keywords: Forward Guidance; Optimal Policy under Commitment; Zero Lower Bound;

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  1. Levine, Paul & Pearlman, Joseph G. & Pierse, Richard, 2007. "Linear-quadratic approximation, external habit and targeting rules," Working Paper Series, European Central Bank 0759, European Central Bank.
  2. Alexander L. Wolman, 1998. "Staggered price setting and the zero bound on nominal interest rates," Economic Quarterly, Federal Reserve Bank of Richmond, Federal Reserve Bank of Richmond, issue Fall, pages 1-24.
  3. Amato, Jeffery D. & Laubach, Thomas, 2003. "Estimation and control of an optimization-based model with sticky prices and wages," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 27(7), pages 1181-1215, May.
  4. Volker Wieland & Gunter Coenen, 2003. "The Zero-Interest-Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," Computing in Economics and Finance 2003 138, Society for Computational Economics.
  5. Adam, Klaus & Billi, Roberto M, 2003. "Optimal Monetary Policy Under Commitment with a Zero Bound on Nominal Interest Rates," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4111, C.E.P.R. Discussion Papers.
  6. Anton Nakov, 2008. "Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 4(2), pages 73-127, June.
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  8. Benigno, Pierpaolo & Woodford, Michael, 2012. "Linear-quadratic approximation of optimal policy problems," Journal of Economic Theory, Elsevier, vol. 147(1), pages 1-42.
  9. Eric M. Leeper & Christopher A. Sims, 1994. "Toward a Modern Macroeconomic Model Usable for Policy Analysis," NBER Chapters, in: NBER Macroeconomics Annual 1994, Volume 9, pages 81-140 National Bureau of Economic Research, Inc.
  10. Jung, Taehun & Teranishi, Yuki & Watanabe, Tsutomu, 2005. "Optimal Monetary Policy at the Zero-Interest-Rate Bound," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 37(5), pages 813-35, October.
  11. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 58(1), pages 17-34, January.
  12. David Reifschneider & John C. Williams, 1999. "Three lessons for monetary policy in a low inflation era," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1999-44, Board of Governors of the Federal Reserve System (U.S.).
  13. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
  14. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  15. Coenen, Guenter & Wieland, Volker, 2003. "The Zero-Interest-Rate and the Role of the Exchange Rate for Monetary Policy in Japan," CFS Working Paper Series 2003/09, Center for Financial Studies (CFS).
  16. Tomohiro Sugo & Yuki Teranishi, 2008. "The Zero Interest Rate Policy," IMES Discussion Paper Series 08-E-20, Institute for Monetary and Economic Studies, Bank of Japan.
  17. Winfield W. Riefler, 1958. "Open market operations in long-term securities," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.), issue Nov, pages 1260-1274.
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Citations

RePEc Biblio mentions

As found on the RePEc Biblio, the curated bibliography for Economics:
  1. > Macroeconomics > Monetary Theory
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Cited by:
  1. Bodenstein, Martin & Hebden, James & Nunes, Ricardo, 2012. "Imperfect credibility and the zero lower bound," Journal of Monetary Economics, Elsevier, Elsevier, vol. 59(2), pages 135-149.
  2. Fahr, Stephan & Motto, Roberto & Rostagno, Massimo & Smets, Frank & Tristani, Oreste, 2011. "A monetary policy strategy in good and bad times: lessons from the recent past," Working Paper Series, European Central Bank 1336, European Central Bank.
  3. Michael Woodford, 2010. "Optimal Monetary Stabilization Policy," NBER Working Papers 16095, National Bureau of Economic Research, Inc.
  4. Hatcher, Michael C. & Minford, Patrick, 2013. "Stabilization policy, rational expectations and price-level versus inflation targeting: a survey," Cardiff Economics Working Papers E2013/14, Cardiff University, Cardiff Business School, Economics Section.
  5. Michael, Hatcher, 2013. "Indexed versus nominal government debt under inflation and price-level targeting," SIRE Discussion Papers, Scottish Institute for Research in Economics (SIRE) 2013-56, Scottish Institute for Research in Economics (SIRE).
  6. Gerberding, Christina & Gerke, Rafael & Hammermann, Felix, 2012. "Price-level targeting when there is price-level drift," Journal of Macroeconomics, Elsevier, Elsevier, vol. 34(3), pages 757-768.
  7. Carlstrom, Charles & Fuerst, Timothy & Paustian, Matthias, 2012. "Inflation and output in New Keynesian models with a transient interest rate peg," Bank of England working papers 459, Bank of England.
  8. Hess Chung & Edward Herbst & Michael Kiley, 2014. "Effective Monetary Policy Strategies in New-Keynesian Models: A Re-Examination," NBER Chapters, in: NBER Macroeconomics Annual 2014, Volume 29 National Bureau of Economic Research, Inc.
  9. Tambakis, Demosthenes N., 2014. "On the risk of long-run deflation," Economics Letters, Elsevier, vol. 122(2), pages 176-181.
  10. Bennani, Hamza, 2014. "The art of central banks' forward guidance at the zero lower bound," MPRA Paper 57043, University Library of Munich, Germany.
  11. Kiley, Michael T., 2014. "Policy Paradoxes in the New Keynesian Model," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2014-29, Board of Governors of the Federal Reserve System (U.S.).
  12. Gavin, William T. & Keen, Benjamin D. & Richter, Alexander & Throckmorton, Nathaniel, 2013. "The stimulative effect of forward guidance," Working Papers 2013-38, Federal Reserve Bank of St. Louis, revised 30 Apr 2014.
  13. Jouchi Nakajima & Shigenori Shiratsuka & Yuki Teranishi, 2010. "The Effects of Monetary Policy Commitment: Evidence from Time- varying Parameter VAR Analysis," IMES Discussion Paper Series 10-E-06, Institute for Monetary and Economic Studies, Bank of Japan.
  14. Maria Lucia Florez-Jimenez & Julian A. Parra-Polania, 2014. "Forward guidance with an escape clause: When half a promise is better than a full one," BORRADORES DE ECONOMIA 011143, BANCO DE LA REPÚBLICA.
  15. Michael Hatcher, 2013. "Aggregate and welfare effects of long run inflation risk under inflation and price-level targeting," Working Papers, Business School - Economics, University of Glasgow 2013_03, Business School - Economics, University of Glasgow.
  16. Kozo Ueda, 2010. "A Time-Invariant Duration Policy under the Zero Lower Bound," IMES Discussion Paper Series 10-E-12, Institute for Monetary and Economic Studies, Bank of Japan.

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