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Optimal Forward Guidance

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  • Bilbiie, Florin Ovidiu

Abstract

For how long should central banks keep interest rates low, beyond the end of a liquidity trap? I solve analytically for the optimal duration of forward guidance (FG), modelled stochastically through a probability of low interest rates once out of the trap. Welfare-maximizing FG balances the benefit of higher consumption (and lower volatility) today with the cost of higher volatility once the trap is over. Its main determinants are the trap duration, the severity of the recession, and a composite parameter capturing the elasticity of aggregate activity to news. A simple rule (announcing an FG duration of half the trap duration times the interest rate spread, plus half a period) is close to optimal. I apply this analytical apparatus to models with heterogenous agents, and study how optimal FG depends on informational asymmetries, financial constraints, and unemployment risk.

Suggested Citation

  • Bilbiie, Florin Ovidiu, 2016. "Optimal Forward Guidance," CEPR Discussion Papers 11251, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:11251
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    Cited by:

    1. Philippe Andrade & Gaetano Gaballo & Eric Mengus & Benoît Mojon, 2019. "Forward Guidance and Heterogeneous Beliefs," American Economic Journal: Macroeconomics, American Economic Association, vol. 11(3), pages 1-29, July.
    2. Nakata, Taisuke & Ogaki, Ryota & Schmidt, Sebastian & Yoo, Paul, 2019. "Attenuating the forward guidance puzzle: Implications for optimal monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 90-106.
    3. Bilbiie, Florin Ovidiu, 2017. "The Puzzle, the Power, and the Dark Side: Forward Guidance Redux," CEPR Discussion Papers 12231, C.E.P.R. Discussion Papers.
    4. Florin Bilbiie & Xavier Ragot, . "Optimal Monetary Policy and Liquidity with Heterogeneous Households," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    5. Roulleau-Pasdeloup, Jordan, 2020. "Optimal monetary policy and determinacy under active/passive regimes," European Economic Review, Elsevier, vol. 130(C).
    6. Rodríguez Arosemena, Nicolás, 2018. "The Dominium Mundi Game and the Case for Artificial Intelligence in Economics and the Law," MPRA Paper 90560, University Library of Munich, Germany.
    7. André, Marine-Charlotte & Traficante, Guido, 2020. "Forward Guidance in Small Open Economy," MPRA Paper 104600, University Library of Munich, Germany.
    8. Bilbiie, Florin Ovidiu, 2018. "Complementarity, Income, and Substitution: A U(C,N) Utility for Macro," CEPR Discussion Papers 12812, C.E.P.R. Discussion Papers.
    9. Bilbiie, Florin Ovidiu, 2018. "Neo-Fisherian Policies and Liquidity Traps," CEPR Discussion Papers 13334, C.E.P.R. Discussion Papers.
    10. Gavin Goy & Cars Homme & Kostas Mavromatis, 2018. "Forward Guidance and the Role of Central Bank Credibility," DNB Working Papers 614, Netherlands Central Bank, Research Department.
    11. Bilbiie, Florin Ovidiu, 2017. "The New Keynesian Cross: Understanding Monetary Policy with Hand-to-Mouth Households," CEPR Discussion Papers 11989, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    forward guidance; hand-to-mouth.; heterogenous agents; heterogenous beliefs; incomplete markets; liquidity trap; Optimal monetary policy; unemployment risk; zero lower bound;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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