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The Limits of Central Bank forward Guidance under Learning

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  • Stephen J. Cole

    (Marquette University)

Abstract

This paper investigates the effectiveness of central bank forward guidance while relaxing two standard macroeconomic assumptions: rational expectations and frictionless financial markets. The results show that the addition of financial frictions amplifies the differences between rational expectations and adaptive learning to forward guidance. During a period of economic crisis, output under rational expectations displays more favorable responses to forward guidance than under adaptive learning. These differences are exacerbated when compared with a similar analysis without financial frictions. Thus, monetary policymakers should consider the way in which expectations and credit frictions are modeled when examining the effects of forward guidance.

Suggested Citation

  • Stephen J. Cole, 2020. "The Limits of Central Bank forward Guidance under Learning," International Journal of Central Banking, International Journal of Central Banking, vol. 16(4), pages 199-250, September.
  • Handle: RePEc:ijc:ijcjou:y:2020:q:3:a:5
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. The Limits of Central Bank Forward Guidance under Learning
      by Christian Zimmermann in NEP-DGE blog on 2016-06-10 19:11:50

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    Cited by:

    1. Greta Meggiorini & Fabio Milani, 2021. "Behavioral New Keynesian Models: Learning vs. Cognitive Discounting," CESifo Working Paper Series 9039, CESifo.
    2. Parra-Polania Julian A., 2019. "State-Dependent Forward Guidance and the Problem of Inconsistent Announcements," German Economic Review, De Gruyter, vol. 20(4), pages 1019-1027, December.
    3. Cole, Stephen J., 2018. "The effectiveness of central bank forward guidance under inflation and price-level targeting," Journal of Macroeconomics, Elsevier, vol. 55(C), pages 146-161.
    4. Cole, Stephen J., 2020. "The influence of learning and price-level targeting on central bank forward guidance," Journal of Macroeconomics, Elsevier, vol. 65(C).
    5. Stephen J. Cole & Fabio Milani, 2020. "Heterogeneity in Individual Expectations, Sentiment, and Constant-Gain Learning," Working Papers 192005, University of California-Irvine, Department of Economics.
    6. Edward Nelson, 2021. "The Emergence of Forward Guidance As a Monetary Policy Tool," Finance and Economics Discussion Series 2021-033, Board of Governors of the Federal Reserve System (U.S.).
    7. Cole, Stephen J. & Milani, Fabio, 2019. "The Misspecification Of Expectations In New Keynesian Models: A Dsge-Var Approach," Macroeconomic Dynamics, Cambridge University Press, vol. 23(3), pages 974-1007, April.
    8. de Groot, Oliver & Mazelis, Falk & Motto, Roberto & Ristiniemi, Annukka, 2021. "A toolkit for computing Constrained Optimal Policy Projections (COPPs)," Working Paper Series 2555, European Central Bank.
    9. Stephen J. Cole & Enrique Martinez-Garcia, 2019. "The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model," Globalization Institute Working Papers 375, Federal Reserve Bank of Dallas, revised 20 Mar 2021.

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    More about this item

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General

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